Thoroughly understanding your business’ financial performance is critical
for success in today’s increasingly competitive agricultural environment.
Accurate records and financial statements are the foundation material
required to analyze the financial condition and trends of your operation.
All agricultural businesses, from small part-time farms to large commercial
operations, require financial statements completed on a regular basis to
track financial progress including equity, liquidity, income, and cash flow.
How do financial statements prove useful?
As a tool for management
Successful managers use financial statements in combination with production
records to identify strengths and weaknesses in their operation. In addition to
tracking trends in assets and liabilities, financial statements can reveal where
revenues are originating and where expenses are occurring. Financial statements
can be used to time cash expenditures and plan for credit needs. Finally, these
statements provide the critical data for ratio analysis and benchmarking.
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Financial Statements
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As a tool for use with lenders and
other professionals
Lenders request, and in most cases require,
an accurate set of financial statements to
accompany a credit request. A carefully
prepared set of financial statements shows
you have a detailed understanding of your
business and its repayment capacity. Others,
such as attorneys and financial planners,
also need financial statements for services
such as estate and retirement planning,
organizational establishment, and buy-sell
agreements for business transition purposes.
As a tool for tax compliance
A carefully prepared set of financial
statements can make life much easier when
tax time comes around.
This prevents last minute information
collection and provides peace of mind
in an IRS audit. Financial statements can
be prepared by individuals, in-house
employees or accountants. Statements
prepared by accountants will range from
simply compiling a business owner’s
numbers, to reviewing and reconciling
numbers, to a formal, unqualified audit.
Even if you have an accountant that keeps
your operation’s books and prepares your
taxes, it’s still important to understand
how financial statements are prepared.
Although accountants are professionals
and are knowledgeable in their field, no one
understands your business like you do.
Financial statements include the balance
sheet, income statement, statement of
owner equity, statement of cash flows, and
cash flow projection. Our discussion will
focus on the three most commonly used
financial statements: the balance sheet,
income statement and cash flow projection.
Financial statements are interrelated;
therefore, proper timing of the statements is
important to gain the most benefit.
Balance sheet
The balance sheet is a statement of financial
position at a specific point in time or a
financial snapshot of the business. The balance
sheet reflects the result of all past transactions
but not how the current financial position was
obtained. The balance sheet consists of three
main parts:
Assets
Assets include anything that is owned by
the entity that has monetary value. Standard
accounting practices value assets at either
cost, market value or the lower of the cost or
market, depending on what is preferred by the
person preparing or requesting the balance
© 2008 Northwest Farm Credit Services, Spokane, WA. All Rights Reserved. Reproduced with permission only.
sheet. Assets valued on a cost basis are listed
at the historical cost less any accumulated
depreciation. Market valued assets are listed
at fair market value based on the asset’s
condition, location or other relevant factors.
Assets valued at the lower of cost or market
are assigned either the cost value or the
market value, whichever is lower. Assets should
be separated into two categories: current and
non-current. A more detailed discussion of
asset classification will follow.
Liabilities
Liabilities include all claims against the
business by creditors, suppliers or any other
person or institution to which a debt is
owed. Liabilities, like assets, are classified
into current and non-current categories.
Owner equity
Owner equity, or net worth, is the difference
between total assets and total liabilities. It
reflects the owner’s stake in the business
and includes investment capital and
retained profits. In a corporate business
structure, owner equity will include
stockholder’s equity, additional paid-in
capital and retained earnings.
Assets
Current Assets
Current assets are the first classification of
assets appearing on the balance sheet. Current
assets include items such as cash or assets
that can and will be turned into cash within
a year without disrupting normal business
operations. Current assets also include any
items that will be consumed within a year.
Examples of current assets include:
•
Cash - Any cash on hand in checking or
savings accounts.
•
Marketable securities - Stock or other
securities that are publicly traded and
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Preparing Agricultural
Financial Statements
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can be easily turned to cash. This would
include only those securities which the
owner intends to convert to cash within
the year. Stock or other securities held for
long-term investment or for retirement
should be considered non-current assets.
•
Accounts receivable - Any amounts
owed to the business for products or
services provided for which payment has
not been received.
•
Marketable inventories - Crops and
livestock held for sale. Do not include
breeding livestock, as they are considered
non-current assets.
•
Cash investment in growing crops -
The dollar amount of inputs invested in
growing crops after planting but before
harvest.
•
Supplies - Any items such as fertilizer,
chemicals or feed that are on hand and
scheduled to be used in the next year.
•
Prepaid expenses - Items that have
been paid for but not yet consumed in full
(examples include insurance premiums,
rent or lease payments, and certain taxes).
Non-current assets
The second classification of assets is
non-current assets. These assets support
production activities and are considered
to have a life greater than one year. In
agriculture, common non-current assets
include machinery and equipment. Breeding
livestock are classified as non-current assets.
If a personal balance sheet is prepared,
non-current personal assets may be
included, such as household furnishings
and equipment, personal and recreational
vehicles, and personal retirement accounts.
Another major category of non-current
assets is real estate, including land, buildings
and improvements. A personal residence
may also be included, if the balance sheet is
prepared for a consolidated entity.
Liabilities
Similar to assets, liabilities are also classified
as either current or non-current. The liability
section of the balance sheet should include
all obligations (classified based on repayment
schedule) as of the date of the balance sheet.
Current liabilities
Current liabilities include all debts and
obligations that are due within the next 12
months. Examples of some common current
liabilities are:
•
Accounts Payable - Money owed to
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suppliers or other businesses for products
or services your business has received but
not yet made payment for.
•
Operating loans - Any outstanding
balances on revolving or non-revolving
operating lines of credit.
•
Principal portion of term loans due
within the next year - The total amount
of principal on term loans that is due to
be paid within the year.
•
Accrued interest - The amount of
interest that has accrued on all loans. This
is the total amount of interest that would
be due if all loans were paid off as of the
day of the balance sheet – it is not the
total amount of interest due to be paid in
the next 12 months.
•
Accrued income and property taxes
- Property taxes are typically paid in a
period following when they are incurred,
and income taxes are paid as frequent as
every quarter, so the balance sheet will
often reflect some accrued tax liability.
•
Other accrued expenses - Items such as
rents and leases that have been utilized but
not yet paid would be accrued expenses.
•
Credit card debt - Credit card debt,
including principal and interest, is
included as a current liability. It’s common
in agriculture for loans to be financed
for one year with the option of renewal
at the end of the year given acceptable
repayment performance. If the lender is
under no obligation to renew the loan
at the end of the original agreement, the
liability should be classified as a current
liability. This treatment may distort
financial ratios, but legally the entire
obligation is due at the end of one year.
Non-current liabilities
Non-current liabilities capture all obligations
that are due and payable beyond one year.
The most common non-current liabilities
are term loans used to finance machinery,
equipment, breeding livestock, or real estate.
The portion of the term loan due beyond 12
months is considered a non-current liability.
Remember the principal amount due within
12 months is a current liability.
Contingent liabilities
Another category of liabilities is contingent
liabilities, which includes such items as
guarantees, pending lawsuits, and federal
and state tax disputes. These items appear
as footnotes to the balance sheet and
are not liabilities at the present, but the
potential for an obligation exists.
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Owner Equity
Owner equity is a residual amount after
liabilities are subtracted from assets (see
Exhibit 1 below and Exhibit 2 on the next
page). Owner equity reflects the owner’s
investment of capital into the business and
retained earnings which are generated over
time. Retained earnings are profits that have
been reinvested back into the business rather
than withdrawn by the owners or paid out in
dividends in the case of a corporation.
Balance sheet considerations
The ownership structure of agricultural
businesses is becoming increasingly
complex. The traditional sole proprietorship
is no longer the norm in agriculture.
Combinations of partnerships, corporations,
and limited liability companies are quickly
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Preparing Agricultural
Financial Statements
8
emerging with one entity holding operating
assets and another entity controlling the
capital assets. It is essential to identify the
entity for which the balance sheet is being
prepared, such as business, personal or a
consolidation of both.
Timing
For analysis purposes, the timing of the
balance sheet is important. Balance sheets
are most useful when they consistently
coincide with the timing of the income
statement, usually at fiscal year-end, which
is typically the end of the income period.
The accrual adjusted income statement
(discussed later) combines other data,
including changes in the beginning and
end-of-year balance sheets.
Asset valuation
A balance sheet is only as valuable as the
quality of the information used to prepare
it. When valuing assets on a market basis, a
conservative approach is preferred, based
upon appraisals and recent sales data in
the market. When preparing a balance
sheet, it’s important to distinguish between
possession and ownership of assets. If a
partial interest in property is owned, then
only that portion should be reflected as an
asset on the balance sheet. Ownership issues
also arise in the case of “life estates” and
lease agreements.
When crop and livestock inventories are
included on the balance sheet, they should
be accompanied by a schedule detailing the
amount and value of each item, indicating
how the total value was derived.
Often a person is involved in more than
one business venture. If so, information
about assets and liabilities associated with
other businesses should be identified. One
business may show significant equity while
another is heavily leveraged. Lenders are
likely to request a consolidated balance
sheet that combines all business and
personal assets and liabilities.
Valuing leases
Numerous valuation issues arise when
preparing balance sheets which exceed
the scope of this discussion. An issue is
that of capital leases for items such as
tractors, combines, irrigation equipment,
and storage structures. In the past, many
lease obligations were simply included as
footnotes to the balance sheet. However,
these types of leases should be included on
the balance sheet.
There are two types of leases: operating
leases and capital leases. Operating leases
allow the lessee the right to use an asset for
a relatively short period of time. Operating
leases should appear as a note to the
balance sheet (unless prepaid or past due),
similar to the rental of farm land. A capital
lease is a direct substitute for purchase of
the asset with borrowed money. It transfers
substantially all the benefits and risks
inherent in the ownership of the property to
the lessee. To be considered a capital lease,
the agreement must meet any one of the
following tests:
•
The lease transfers ownership of property
to the lessee at the end of the term.
•
The lease contains a bargain purchase
option.
•
The term of the lease is at least 75 percent
of the estimated economic life of the
property.
•
The present value of the minimum lease
payment equals or exceeds 90 percent
of the fair market value of the leased
property.
Exhibit 3 below, illustrates an example of
a five-year capital lease agreement with
annual payments (due at the beginning of
the period) of $11,991. The lease is treated
similar to an equal payment, amortized loan
and must be reflected as both an asset and
a liability on the balance sheet. Although
there is no interest rate stated in the
agreement, an $11,991 annual payment for
five years at an “imputed interest rate” of 10
percent results in a present value of $50,000.
This is the initial lease value (both asset and
liability). Remember, it’s the lease investment
which is being put on the balance sheet, not
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Preparing Agricultural
Financial Statements
10
the asset being leased.
Also in Exhibit 3, the asset is listed as a non-
current asset each year. The principal due
within the year and any accrued interest as
of the date of the statement are listed as
current liabilities, and the remaining lease
obligation is a non-current liability.
Deferred taxes
As discussed earlier, assets can be valued
on the balance sheet, either on a cost or
market value basis. A market value balance
sheet reflects the impact of deferred tax
liabilities (refer back to Exhibits 1 and 2 on
pages 6 and 7). Deferred taxes are the federal
and state taxes that would be incurred
if the business was liquidated. Deferred
taxes on current assets arise because many
agricultural producers report income on a
cash rather than accrual basis for income
tax purposes. Therefore, they do not pay
taxes on the accumulation of crop and
livestock inventories over time. Income taxes
would be due if inventories were sold and
if the expenses associated with them had
previously been deducted as cash expenses.
Deferred taxes may also be present on non-
current assets. Two examples of deferred tax
situations are:
•
Market value of assets exceeds cost less
accumulated depreciation.
•
Sales price of purchased breeding
livestock exceeds the original cost.
Income statement
A business income statement, also called a
profit and loss statement, is used to measure
revenues and expenses over an accounting
period. Unlike the balance sheet, which
reflects the financial position at any given
point in time, the income statement shows
income and expenses for a period of time,
usually one year. Income statements can be
used to determine income tax payments,
analyze a business’ expansion potential,
evaluate the profitability of an enterprise, and
assist in loan repayment analysis.
Identify entity
Identifying the business entity is also
important when preparing an income
statement. The income statement
should be prepared for the same entity
as the balance sheet, either business,
personal or consolidated. Because of the
interrelationship between the balance sheet
and income statement, the time period
covered by the income statement should be
the time between the beginning and ending
balance sheets. The most common period
is annually, although quarterly or monthly
statements are sometimes desired.
Revenues and expenses
All income statements include two
categories: revenues and expenses. However,
income statements can be prepared two
ways, depending on how revenues and
expenses are derived. A cash income
statement measures revenues only when
received and expenses only when paid.
An accrual income statement measures
revenues when generated and expenses
when incurred, whether or not cash actually
changes hands. The cash income statement
(illustrated in Exhibit 4) is the easiest to
prepare but is inadequate for measuring
true profitability because it fails to match
the timing of income and expenses.
Depreciation
Depreciation, although not a cash expense,
is included on both the cash and accrual
income statements as a way of spreading
the cost of capital purchases over their
useful life. Accelerated depreciation is
frequently used for tax purposes. If this is
the case, it should be noted accelerated
depreciation is being used, because it could
distort profitability.
Schedule F
The Schedule F tax form is often used as an
income statement. Although the Schedule
F can offer some valuable insight, it is not
an income statement and should not be
used as such. However, in some cases it can
be used effectively if three to five years of
information is provided and the business is
in a stable operating mode with no major
adjustments. Using a series of Schedule Fs
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Preparing Agricultural
Financial Statements
12
as an income tax statement rests on the
assumption shifting income and expenses
will even out over the years.
Accrual-adjusted statements
The Farm Financial Standards Council
recommends the use of an accrual-adjusted
income statement. Ideally, a business’
accounting records will produce an accrual
statement; however, in practice, adjustments
are made to the cash income statement
(or Schedule F) to gain an accrual-adjusted
income statement. Exhibit 5 above
illustrates how accrual adjustments are
made. To convert cash income to accrual-
adjusted income, we must look at changes
between the beginning-of-year and end-
of year balance sheets. Adjustments to
revenue include changes in inventories
and accounts receivable. In the expense
section, adjustments are made for changes
in unused assets, prepaid expenses, accrued
expenses, and accounts payable. Gains or
losses on the sale of capital assets are also
added or subtracted.
Revenues and expenses can come from a
variety of sources in an agricultural business.
Categories of revenues that are usually
included in an income statement are:
•
Realized cash revenues from the sale of
agricultural commodities.
•
Unrealized income from changes in the
quantity or value of crop and livestock
inventories.
•
Realized capital gains from the sale of
capital assets.
•
Income from custom work and
government payments.
Expense items included on the income
statement vary with the type of business
but include all operating expenses, interest
and depreciation.
Cash flow projection
The balance sheet and income statement
provide present and historical financial
information that reflect past financial
performance of a business. However,
producers and lenders are often equally, if not
more, interested in future performance. For this
reason, a cash flow projection is a valuable
financial tool.
A cash flow projection summarizes cash
inflows and outflows over a given period. A
projection can be prepared for the business,
individual or a consolidation of both, similar
to the balance sheet and income statement.
The cash flow projection can be useful for
preparing projected income statements and
balance sheets and for determining:
•
The need for operating lines of credit to
cover cash flow deficits.
•
Periods of excess cash when funds could
be placed in income-earning assets such
as money markets or the Future Payment
Fund offered by Northwest Farm Credit
Services.
•
The need for changes in marketing or
expenditure plans.
•
The cash flow feasibility of a new
investment.
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14
•
The cash flow in a transition year before
the operation is fully engaged.
Components
While cash flow statement formats can vary,
there are three basic components: cash
inflows, cash outflows and operating finance
activities.
Exhibit 6 on the next page illustrates a
cash flow projection. Cash inflows include
receipts from farm and nonfarm activities
that are divided into relevant categories for
the type of business being examined. Cash
outflows include a detailed listing of cash
expenses as well as principal and interest
payments on term debt.
Note depreciation does not appear on the
cash flow projection because it’s not a cash
expense and will not impact cash flow. The
operating finance activities section outlines
the net cash flows for each quarter along
with the short-term borrowing needs,
interest accrued and repayment of the line
of credit.
Different scenarios
A one-year projection can be completed for
different scenarios to examine price, cost
and related impacts.
Cash flow projections for multiple years may
also be useful when development is being
done, in order to project cash needs prior to
full production or adequate production to
break even.
Different cash flow scenarios may include:
“How would cash flow be affected if
commodity prices were 50 cents lower
than expected?” or “What is the impact of
a 10 percent increase in fertilizer costs?”
Testing these options helps identify
how sensitive an operation or projected
scenario is to changes in the market
environment. It’s important to remember
a cash flow projection is only as good as
the assumptions and information used to
prepare it.
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Preparing Agricultural
Financial Statements
Whether you are preparing your own
statements, or analyzing those prepared
by an accountant, this publication should
provide a good basic understanding
of how to prepare financial statements
that are valuable both internally as a
management tool, and externally for use
with outside professionals.
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