As a beginning farmer you will probably be concentrating on daily or weekly activities such as improving your production techniques, building your customer base and developing a following, the physical activities of harvesting and selling your product, etc. As your farm business grows and your production and sales increase you will need to start using the financial information you collect to help manage your business. Financial Statements provide an overview of your financial condition in both the near- and long-term. The first step is to collect the information needed to prepare your Balance Sheet, Income Statement, and Cash Flow Budget. Financial analyses are performed on these statements to provide you a more detailed analysis of your operations.
Why is this important?
Financial Statements provide information about the financial position, performance and changes in the financial position of your company to help you make important business decisions. Using ratio analysis, these Financial Statements can help you determine the financial health of your business.
Balance sheet
A Balance Sheet shows your financial position at a specific point in time and reflects the following basic relationship:
Assets = Liabilities + Net Worth (Owner Equity)
Assets – Resources or items of monetary value that are controlled by the business. Assets are listed in order of their liquidity, i.e., when they will be used up.
Current assets, listed first, will be converted to cash or consumed during the upcoming year. Intermediate assets come second and provide services to the business over time, but they are used up (depreciated) or sold (liquidated) within two to ten years. Long-term or fixed assets are last and are those items that normally do not wear out or are not intended for sale within the next ten years.
Liabilities – Debts owed by a business. Liabilities are listed on the Balance Sheet in the order in which they come due.
Current liabilities, listed first, will be due during the upcoming year. Intermediate liabilities, come second and are debt obligations due within two to ten years. Finally, long-term or fixed liabilities are those debts due in more than ten years.
Net Worth or Owner’s Equity – The current value of the owner’s investment in the business. This figure will include investments by the owner in the business and profits that have been retained in the business rather than withdrawn by the owner.
Income statement
Income Statement summarizes the revenues and expenses of your business during a specific period of time, generally a year. Many businesses use the profit-and-loss statement from their income tax form as their Income Statement.
Cash flow budget
A Cash Flow Budget estimates all of the cash coming into and going out of your business over the year. To make these forecasts, you must anticipate all of the following cash flows every month.
Cash In:
+ cash sales
+ payment for credit sales
+ new loans
+ owner’s investment
+ asset sales
Cash out:
– operating expenses
– interest and tax payments
– loan payments
– owner’s withdrawal
– asset purchases
After the cash flow budget is completed, the budget can be used to project your Balance Sheet and Income Statement in the future. You might want to anticipate what you will do if sales are not as strong as expected or if an un-planned expense occurs, so that you are prepared for cash flow problems that might arise.
Financial analysis
Two of the most commonly used financial analyses are Break-even Analysis and Ratio Analysis.
Break-even Analysis – Break-even Analysis estimates the minimum number of units that a company must sell, or the minimum selling price that the company must receive, in order to pay all of its expenses. To calculate the minimum selling price or minimum number of units, see the lesson on cost of production in this Guidebook. Knowing the number of units that you must sell to pay your expenses, or your minimum sales price, is useful because it is a goal that you can shoot for. Other financial goals are also important, and Ratio Analysis allows you to look at them.
Ratio Analysis – Ratio Analysis uses information from your Balance Sheet and Income Statement to compute ratios that describe your financial position.
Four financial goals are important to your business. Ratios can be used to determine where your business stands in each of these areas.
Liquidity: The ability of a business to pay bills and debts as they become due over the next year.
The most widely used Liquidity indicators are the Cash Flow Budget and the Current Ratio. Because the Cash Flow Budget is prepared a year in advance, it can help you anticipate any cash shortage that you need to be prepared to address.
Current Ratio = Current Assets/Current Liabilities
A low Current Ratio, say 1:1, means that your business is barely liquid and you may not be able to pay your debts when they become due this year. A high Current Ratio, say 3:1, means that your business is very liquid. This may limit your business’ profitability because current assets generally earn less than intermediate and long-term assets.
Solvency: The ability of a business to pay off all debts over the life of the business.
The most common Solvency measure is the Leverage Ratio:
Leverage Ratio = Total Liabilities/Net Worth
If your Leverage Ratio is large, say 2:1, your business has a large amount of debt and could go bankrupt quickly. On the other hand, a small Leverage Ratio, ~1:5, means that your risk of bankruptcy is much smaller, but your opportunities to grow and make profits are reduced.
Profitability: The ability of the business to earn profits.
Two common measures of Profitability are Return on Assets (ROA) and Return on Equity (ROE). In calculating ROA and ROE, the figure subtracted for unpaid labor will depend on how much you think this labor is worth. Generally, you should think in terms of how much it would cost to hire someone to do the work that you or a family member currently does.
Return on Assets = (Net income+Interest paid-Total unpaid labor)/Total Assets
ROA indicates the before-tax rate of return earned by the assets of the business. The interest paid on debts is added back in before ROA is calculated. The ROA of a business must be greater than the interest rate on borrowing or the assets are not earning enough to pay for themselves.
Return on Equity = (Net income – Total unpaid labor)/Total net worth
Remember that the ROE tells you how much your business is earning on the money you have invested in it. Looking at the returns you could get from other investments will help you decide whether your ROE is acceptable.
Financial Efficiency: The value of inputs as compared to the value of output they produced.
Operating expenses ratio = (Total expenses – Interest paid – Depreciation)/Sales
Various efficiency ratios calculated with data from your Income Statement determine how much of each sales dollar is paid out for expenses or remains as profit. If large expenses such as labor go up without sales increasing at the same time, then you will know that your business is operating less efficiently.
Things to remember when using ratio analysis
- Examine the ratios computed from data contained in your company’s Financial Statements to determine whether this value is consistent with your goals. For example, if you want to pursue a goal of high profitability, you may want to be sure that your current ratio is not high.
- Compare your business with similar businesses in the industry. Get information at the library, from trade magazines or associations, or from lenders.
- Do not use only one ratio for decision making. Moving toward one goal may result in movement away from another. For example, a movement toward profitability might lead away from high liquidity.
Next steps and resources
- Analyze your ratios over time and make decisions based on trends rather than on one year’s performance. Make a chart to see how things change over time. Be sure that you have your business’ financial data at your fingertips and check it often. You can congratulate yourself on things that went according to plan and correct problems before they get out of hand. You might also want to reassess your goals periodically if your business goals have changed over time.
The information in this lesson was updated from the book, “This Hawaiʻi Product Went to Market” in the “Managing Your Finances” section authored by Linda J. Cox.