farm management chapter 6 the income statement and its analysis
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Farm Management
Chapter 6The Income Statement
and Its Analysis
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Chapter Outline
• Identifying Revenue and Expenses
• Income Statement Format
• Accrual Adjustments to a Cash-Basis Income Statement
• Analysis of Net Farm Income
• Change in Owner Equity
• Summary
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Chapter Objectives
1. To discuss the purpose and use of an income statement
2. To illustrate the structure and format of an income statement
3. To define the sources and types of revenue and expenses included
4. To show how net farm income is computed and what it means
5. To analyze farm profitability
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What is an Income Statement?
An income statement is a summary of revenues and expenses as recordedover a period of time.
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Figure 6-1 Relation between balance sheet
and income statement
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Identifying Revenue and Expenses
• Revenue: revenue should be recognized as soon as a commodity is ready for sale, whether or not it is actually sold
• Gain or loss on sale of capital assets: difference between sale price and book value
• Expenses: all expenses incurred in producing the revenue for an accounting period should be included
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Income Statement Format
Total revenue
Less total expenses
Equals net farm income from operations
Plus or minus gain/loss on sale of
capital assets
Equals net farm income
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Table 6-1 Income Statement Format
Cash crop salesCash livestock salesInventory changes: Crops Market livestockLivestock product salesGovernment program paymentsChange in value of raised breeding stockGain/loss from sale of culled breeding stockChange in accounts receivableOther farm income Total revenue
Purchased feed and grainPurchased market livestockOther cash operating expenses: Crop expenses Livestock expenses Fuel, oil Labor Repairs, maintenance Property taxes Insurance Other:
Adjustments Accounts payable Prepaid expensesDepreciation Total operating expensesCash interest paidChange in interest payable Total interest expense Total expensesNet farm income from operationsGain/loss on sale of capital assets: Machinery Land Other
Net farm income
Revenue:
Expenses:
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Accrual Adjustments to a Cash-Basis Income Statement
• The FFSC recommends that anyone using cash accounting convert the resulting net farm income to an accrual-adjusted net farm income at the end of each year
• Two adjustments to cash receipts: change in inventory values and accounts receivable
• Several adjustments to expenses, including accounts payable and accrued expenses
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Figure 6-2 Adjustments to get accrual-adjusted net farm income from a cash-basis income statement
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Table 6-2 Income Statement for I.M. Farmer for Year
Ending December 31, 20003Cash crop sales $133,100Cash livestock sales 68,400Inventory changes: Crops (8,000) Market livestock 1,700Livestock product sales 0Government program payments 3,400Change in value of raised breeding stock 0Gain/loss from sale of culled breeding stock 600Change in accounts receivable 1,200Other farm income 0 Total revenue $200,400
Purchased feed and grain 12,000Purchased market livestock 28,000Other cash operating expenses: Crop expenses 44,500 Livestock expenses 6,500 Fuel, oil 3,200 Labor 8,400 Repairs, maintenance 3,600 Property taxes 2,800 Insurance 2,000 Other: Utiliites 2,400
Adjustments Accounts payable 1,000 Prepaid expenses 1,500 Accrued expesnse 0Depreciation 8,200 Total operating expenses 124,100Cash interest paid 30,000Change in interest payable (500) Total interest expense 29,500 Total expenses 153,600Net farm income from operations 46,800Gain/loss on sale of capital assets Machinery 1,100 Land 0 Other 0 1,100
Net farm income $47,900
Revenue:
Expenses:
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Net Farm Income
Net farm income is the amount bywhich revenue exceeds expenses,plus any gain or loss on the sale ofcapital items. It represents the returnto the operator for unpaid labor,management, and equity capital. Net farm income from operations excludes gain or loss on sale of capital items.
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Analysis of Net Farm Income
• Rate of return on assets
• Rate of return on equity
• Operating profit margin ratio
• Return to labor and management
• Return to labor
• Return to management
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Adjusted Net Farm Income
Net farm income from operations $46,800
Plus interest expense 29,500
Equals adjusted net farm income from operations $76,300
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Opportunity Costs of Labor and Management
The opportunity cost of unpaid labor is the estimated amount that any unpaid farmlabor could have earned elsewhere.
The opportunity cost of management is the estimated amount that the operator could have earned for that management time had it been used in paid work.
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Return to Assets
Adjusted net farm income from operations $76,300
Less opportunity cost of unpaid labor -20,000
Less opportunity cost ofmanagement -5,000 Equals return to assets $51,300
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Rate of Return on Assets(ROA)
Rate of return return to assets ($)
average farm asset
= 100%on assets (%)
value
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ROA for I.M. Farmer
$ 51,300
= 100%ROA
$725,750
= 7.07%
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Return on Equity
Net farm income from operations $46,800
Less opportunity cost of unpaid labor -20,000
Less opportunity cost ofmanagement -5,000 Equals return on equity $21,800
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Rate of Return on Equity (ROE)
Rate of return return on equity ($)
average equity ($)
= 100%on equity (%)
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ROE for I.M. Farmer
$ 21,800
= 100%ROA
$358,565
= 6.08%
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Comparing ROA and ROE
If ROA > i then ROE > ROAIf ROA < i then ROE < ROA
Where i is the interest rate on borrowedcapital. Thus, if ROA > ROE borrowed capital is earning, on average, less thanthe interest rate. If ROA < ROE, borrowed capital is earning, on average, more than the interest rate.
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Operating Profit
Net farm income from operations $46,800
Plus interest expense 29,500
Less opportunity cost of unpaid labor -20,000
Less opportunity cost ofmanagement -5,000 Equals operating profit $51,300
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Operating Profit Margin Ratio
operating profit
= 100%Operating profit margin ratio
total revenue
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Operating Profit Margin Ratio for I.M. Farmer
$ 51,300
= 100%Operating profit margin ratio
$200,400
= 25.6%
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Opportunity Cost of Capital
To find the opportunity cost of capital,multiply the opportunity interest rate (e.g. what the capital could earn elsewhere)times the average total asset value.
For I.M. Farmer: $725,750×8% = $58,060
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Return to Labor and Management
Adjusted net farm income from operations $76,300
Less opportunity cost of all capital -58,060 Equals return to labor and management 18,240
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Return to Labor
Return to labor and management $18,240
Less opportunity cost of management -5,000 Equals return to labor $13,240
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Return to Management
Return to labor and management $18,240
Less opportunity cost of labor -20,000 Equals return to management -$1,760
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Change in Owner Equity
• Retained farm earnings: the part of farm earnings, after taxes and personal withdrawals, that is retained for use in the farm business
• A positive retained farm earnings increases owner equity
• If taxes and living expenses are greater than total earnings, owner equity will fall
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Figure 6-3Relation between net farm income
and change in equity
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Summary
An income statement organizes and summarizes revenue and expenses for anaccounting period. Net farm income, orprofit, is a dollar amount, whereas profitability relates profits to the size ofthe business.