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Why Financial Statements?

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It is no surprise to many of you to hear that agriculture is in challenging times. These kinds of conditions, however, do have some very positive implications. In the short run a certain amount of pain is experienced, but there are long-term benefits. We can compare current times in agriculture to the years of attending grade school, high school and for some, college. We endured the pain of homework, hours of studying and the stress of waiting for test results. School was definitely in session and learning was taking place. Short-term (which we thought at the time was an eternity) sacrifices were made in order to receive longterm benefits. The benefits included better communication skills, the ability to read, write, do arithmetic, and think analytically. These skills allowed us to make a greater contribution to mankind and receive more enjoyment during the process.

Those of you who were involved in agriculture during the 1970's may remember me saying that school was not in session for much of that decade. Why? Surviving in production agriculture was relatively easy. Very little management expertise was required. Because of the high rate of inflation, whatever you bought one day was worth more the next. If you borrowed money it could be paid back with cheaper dollars or if not paid back, asset values had increased sufficiently to adequately collateralize the higher debt. In many instances, unpaid annual principal payments and accrued interest were re-amortized into long-term debt. This worked as long as the inflation rate was higher than the interest rate, which was the case during much of the 1970's. Borrowed capital actually had a negative cost.

The decade of the 1980's roared in with double-digit inflation in the rear view mirror. The inflation rate and many asset values went down and interest rates skyrocketed. Borrowed capital went from a negative cost to being very expensive. High levels of debt became quite burdensome at the increased interest rates. With plummeting asset values and deteriorating financial statements, school was back in session for farm and ranch managers. The decade of the 1980's produced excellent graduates for the future of agriculture. Not only were managers better equipped for the challenges of the 1990's and beyond, but so were lenders of agricultural credit. School for managers and lenders is still in session. The short-term pain of preparing realistic net worth and projected cash flow statements will make us better long-term managers. For this to happen, however, serious attention must be given to these documents during their preparation and analysis.

A key element in the amount of benefit we receive from our education is how much we use it once we have gone through the pain of obtaining it. To demonstrate this principle I will use a net worth statement, one of the basic financial documents an owner of a business usually prepares and a lender will require. The net worth statement is a financial picture of a business at a given point in time. This financial picture changes over time just as we change physically over time. Much benefit can be derived from both the one picture taken at a given point in time and the accumulation of the pictures over time. A word of caution, just as in a physical picture that can be manipulated with modern technology to portray a completely different image than real life, so can a financial picture be manipulated. It is usually best not to prepare a net worth statement for your use and another one for the banker.

What should a net worth statement reveal about the business? The first thing most business owners are interested in is liquidity. In other words, if they sold their raised calves, crops and inventory of feed, seed, etc., would the proceeds pay all the operating line of credit and short-term notes? Liquidity is usually measured in terms of the ratio of current assets divided by current liabilities.

The bigger this number is the better. If this number is close to one or less than one for an agricultural operation, it is an indication that financial problems could be on the horizon. Another use of the net worth statement is to compare the amount of total debt owed by the business to the amount of total assets owned by the business. This number is generally calculated as a percentage. The smaller this number is (e.g. 0.25 compared to 0.50), the more stable the business is. When this number is higher than 0.50, the long-term stability of the business is in question.

In my opinion, the greatest benefit of net worth statements is to compare a series of statements which were completed about the same time each year. A financial look at the business at a given point in time reveals the financial health of the business at that time. Observing a series of net worth statements indicates if the health is improving or deteriorating.

It is time consuming and often painful to prepare financial statements. However, I would encourage you to take the time to do the very best job you can with the utmost of integrity. And once they are completed, analyze them and use them to detect early signs of financial stress so appropriate strategies can be implemented to ensure the long-term survival of the farm.