financial analysis

Financial AnalysisAg ManagementChapter 3

Financial Statements Necessary to Determine Financial Condition•Net worth Statement•Income Statement•Cash Flow

Net Worth Statement

Net Worth Statement

•A “snapshot” of a financial situation that lists assets, liabilities, and net worth

3 Parts of Net Worth Statement•Net Worth•Assets•Liabilities

Assets

•Items that have a market value•2 Categories

▫Current▫Non-Current

Current Assets

•Cash or other assets which can be converted to cash through normal operations of business during the year

•Examples▫Checking and/or Savings Accounts▫Receivables▫Inventory held for sale▫Other near-cash items such as securities,

stocks and bonds and the cash value of life insurance

Non Current Assets

•All assets controlled by the farm or ranch business having a useful life greater than 1 year

•2 categories▫Intermediate ▫Fixed

Intermediate Assets (Non Current)•Resources or production items with a

useful life of 1-10 years•Include most assets used to support

production or in the production process•Examples

▫Equipment▫Machinery▫Breeding Livestock

Long Term Assets (Non Current)•Permanent items•Examples

▫Land▫Improvements on buildings

Liabilities

•All the debt obligations of the business•Two types

▫Current▫Non Current

Current Liabilities

•Debts due within the operating year, normally a 12 month period

•Examples▫Notes & accounts payable▫Rents▫Taxes▫Interest plus principle payments due on

intermediate or long-term debt within the next 12 months

Non Current Liabilities

•Debts due past (or after) one year•Two categories

▫Intermediate▫Long Term

Intermediate Liability•Non real estate debt that corresponds to

intermediate assets•Loan terms are normally for a period of 12

months or more but less than 10 years•Examples

▫Loans for Improvements to Real Estate Equipment Purchases Breeding livestock and dairy stock Capital requirements for major adjustments in

farm operations

Long Term Liabilities

•Mortgages and land contracts on real estate minus principle due within 12 months

Net Worth

•The amount of money you can put in your pocket before taxes if you were to sell all your assets and pay off all your liabilities

•Net Worth = Assets-Liabilities•See p. 3-5

Kinds of Financial Analysis

3 Kinds of Financial Analysis

•Comparative•Projected•Ratio

Comparative Analysis

•Measuring and analyzing the trends found in net worth statements over a period of months & years.

•Important to compare the same dates each year

•Looks at Assets, Liabilities & Net Worth

Projected Analysis

•Used to estimate future changes in equity

Making a Projected Analysis

•Making balance sheets for the future for expected farm situations and analyzing them to see problem trends

•Usually made when cash flow statements are made

Ratio Analysis

•Used to measure the financial condition of one farm against other farms

Ratio Analysis Maybe Difficult Because….•Ratio’s showing strengths and

weaknesses may not be clearly defined•What is good for one business may not be

good for another

Financial Analysis from the Net Worth Statement

3 Financial Indicators that can be Calculated from the Net Worth Statement

•Liquidity•Solvency•Equity

Liquidity

•The ability of a business to generate enough cash to pay bills without disrupting business

3 Formulas to Measure Liquidity•Current•Working•Debt Structure

How Current Ratio Measure’s Liquidity•Current Ratio=Current Assets/Current

Liabilities

How Working Capital Measures Liquidity•Total Current Farm Assets – Total Current

Farm Liabilities

What Debt Structure Reveals About Farm Liabilities•Measured by dividing current liabilities

by total liabilities▫Current Liabilities/ Total Liabilities

•The higher this percentage the more assets would be needed to service debt.

Solvency

•Measures the ability of all assets if sold at market value to cover all debts

Calculations to Measure Solvency•Debt-to-Asset Ratio•Debt-to-Equity Ratio•Equity-to-Asset Ratio

Debt-to-Asset Ratio

•Measures the amount of risk in regard to debt against the farm or ranch

•Calculated by▫Total Farm Liabilities/Total Farm Assets

•Lenders prefer to provide loans which are equal to or less than 50 percent of assets.

Debt-to-Equity Ratio

•Shows the relationship between owned and borrowed capital

•Measured by▫Total Liabilities/Net Worth

•Lenders prefer a debt-to-equity ratio of less than 1 because this shows that the owner’s net worth or contribution is more than the borrowed funds

Equity-to-Asset Ratio

•Measures the relationship of the farm’s net worth and total farm assets

•Measured by▫Total Farm Net Worth/Total Farm Assets

•Allows you to see if total assets exceed total liabilities

Income Statements are Used

•Give the figure of either income or figure loss

Income

•Money received from the sale of crops, livestock, and livestock products during the year.

•Receipts should also include government payments and miscellaneous sources of farm income

Expenses

•Money paid out to operate the business

Calculation for Net Cash Income•Net Cash Income =Cash Income – Cash

Expense•Net Cash Income is what remains after

subtracting Operating and Fixed Expenses

Non Cash Adjustments Must Be Made by Comparing and Ending Values for… •Expenses payable•Prepaid expense•Adjustments in inventories•Change in interest payable

Net Farm Income

•Net cash income and the adjustments added together

Financial Efficiency Ratios

Financial Efficiency Ratios

•Ratio’s that compute what percent of total revenue is attributed to the relevant category

Four Financial Efficiency Ratios•Operating-Expense Ratio=

▫Total Expenses-Depreciation and Interest/Total Income

•Depreciation-Expense Ratio=▫Total Depreciation Expense/ Total Income

• Interest-Expense Ratio=▫Total Interest Expense/Total Income

•Net Farm Income From Operations Ratio=▫Net Farm Income From Operations/Total Income

•See p.3-12 fig. 21 for examples

Operating Expense Ratio

•Percent of income that consist of operating expenses. (excluding interest and depreciation expenses)

Depreciation Expense Ratio

•Total depreciation expense divided by total revenue. Indicates the percentage of total income allocated to depreciation.

Interest-Expense Ratio

•Total interest expense (cash interest paid plus change in interest payable) divided by total income. Ratio show the percentage of income devoted to interest.

Net Farm Income From Operations Ratio •Net farm income from operations divided

by total income . Show the percentage or ratio of total income that actually ends up as net farm income from operations.

•Good check is to ensure that all four ratios total to 100%.

Net Worth and Income Statement Relationships

Net Worth Statements Look At

•The financial picture at a point in time.

Income Statements Indicate the Performance of•The farm business within a period

▫The period can be defined as any period but it is typically between one net worth statement and the next (usually 1 year)

Asset-Turnover Ratio

•Useful measure to show how effectively farm assets are being used

•Calculated by▫Gross Revenue/Average Total Farm Assets

Gross Revenue is gross receipts from farming plus (or minus) total non-cash adjustments

Average total farm assets is in year one plus year two divided by two.

Value Favorable for Asset-Turnover Ratio•The higher the asset turnover ratio, the

quicker the turnover of assets and generally the greater the likelihood of profits

Distribution of Net Farm Income (Profitability)

Not Shown on Income Statements

•1 category of labor not shown on income

statements– A charge for unpaid operator and family labor

Operator and Family Labor Allowance•Determined from a 2,080 hour work year

Return to Equity Capital and Management•Return to Equity Capital and Management=Net Farm Income – Operator and Family Labor Allowance

Profitability Ratios• Rate of Return on Borrowed Capital (COD)=

▫ Return on Farm Assets-Return to Equity Capital and Management/Average Total Farm Assets-Average Net Worth

• Rate of Return on Farm Assets (ROA)=▫ Net Farm Income + Total Interest Expense –Operator and

Family Labor Allowance• Rate of Return on Farm Equity (ROE)=

▫ Return to Equity Capital and Management/Average Farm Net Worth

• Operating Profit Margin Ratio (OPMR)=▫ Net Farm Income + Total Interest Expense – Withdrawals

for Operator and Family Labor/ Total Income• See p.3-14 to 3-16 for examples

Rate of Return on Assets Show Profitability by•Adjusting net farm income as if no

interest has been paid, thus treating the total farm assets like equity capital

Rate of Returns on Equity Ratio Is•The rate of return on equity in the farm•The ratio show’s the farm’s return on net

worth

How the Rate of Return on Borrowed Capital is Used•Evaluating whether returns are great

enough to pay the cost of borrowing funds•Comparing return on borrowed capital

with the return on equity capital

Operating Profit Margin Shows Profitability By•Defines profit as a percentage of total

revenue•Formula

▫Net Farm Income + Total Interest Expense – Withdrawals for operator and family labor/ Total Income

3 Components of Ending Net Worth Statement•Ending Assets

▫Beginning Assets + Non-Cash Reinvestment + Changes in Inventory – Depreciation = Ending Assets

•Ending Liabilities▫Beginning Liabilities + New Debt Added –

Debt Repaid = Ending Liabilities•Ending Owner Equity

▫Beginning Owner Equity + Net Farm Income – Family Living and Income Taxes= Ending Owner Equity

Fixed Assets and Net Worth Statements

3 Reasons Valuing Fixed Assets is Difficult•Fixed assets can’t easily be changed to capital

like current and other noncurrent assets•Fixed assets are usually part of the business

for many years; often they are part of the entire life of the business

•Values on financial statements must be estimated in order to get credit and to plan for future enterprises

• It is best to be conservative when valuing fixed assets, therefore it is best to use BOOK VALUE

Summary• Financial statements are like a health report• There are 2 financial statements to consider

▫ Net Worth▫ Income

• Net worth statement and income statement provide financial measures of strengths and weaknesses of the farm business. They help pinpoint problems.

• The Net worth statement provides information about what assets are owned and what liabilities are owed. It is a picture of the farm business at a point in time, usually annually.

• The income statement show the financial performance of the farm business from one net worth statement to another.

• The two financial statements together are powerful tools for farm and ranch business management.

Assignment

•Chapter 3 Assignment Sheets 1 and 2 p. 39-42▫DUE--- Tuesday Sept 21

•Chapter 3 Review Questions▫DUE--- Thursday Sept 23

•Chapter 3 Quiz– Thursday Sept 23