We are completing another calendar business year, and this provides an opportunity to measure the financial progress of your farm/ranch business. Once a financial analysis has been completed, it will provide insight into the relative financial strength of your business.
Profitability is the heartbeat of any farm business. The level of profitability must be high enough to cover all the operation's financial commitments. It is possible to be profitable but not cash flow for the business year. For example, if net farm income (NFI) is $30,000 and principal payments for term debt and family living withdrawals are $45,000, the operation will have a shortage of cash of $5,000 ($30,000 less $45,000 plus depreciation of $10,000). Profitability is calculated by utilizing the cash records for the farm business and making adjustments for these items: changes in crop and livestock inventories; changes in accounts receivable like custom work performed, insurance settlements, government payments, etc.; products consumed by the family; prepaid expenses and unpaid/accrued expenses. Depreciation is a non-cash expense that must be added to the cash expenses to reflect the economic loss of depreciable assets involved in the operation.
NFI is computed by subtracting the farm's expenses from the farm revenue. NFI is an important component in determining the financial productivity of the farm's assets. NFI also is needed when determining return-on-assets (ROA). For example, let's assume:
|Unpaid Family Labor||$25,000|
|Average Annual Farm Asset Value||$500,000|
($40,000 + $10,000 - $25,000)/$500,000 = 5% return-on-assets (ROA)
There are two methods of improving the ROA. Assuming the value of assets is $500,000, the NFI must be increased to improve ROA. In this example, NFI must increase by $5,000 to improve the ROA by 1 percent. The other method of improving ROA is to invest less in assets while maintaining NFI. Most operations have equipment or other assets not being utilized. The sale of these assets, while maintaining NFI, improves the ROA.
Another option would be to engage in changes to the business that combine these two strategies to enhance ROA.
Before you get too far into the new business year, consider spending some time evaluating the profitability of this past year. The information gained from completing an in-depth financial analysis may cause you to change where additional investments are made in your farm/ranch operation.
Remember, you can manage what is measured. So get out the financial yardsticks and begin measuring last year's financial outcomes.