Analyzing Business Opportunities

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Analyzing Business Opportunities
Ray Massey Commercial Ag Program
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Reasons businesses fail

• Insufficient liquidity not enough cash to meet
  obligations when they come due.
• Insufficient solvency not enough assets to pay
  off debts.
• Insufficient profitability not enough revenue
  to cover expenses.

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Accounting Equation
Assets Liabilities Net Worth
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Financial Objective increase net worth
Assets - Liabilities Net Worth
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Balance Sheet
December 31, 2007 _
Assets Current Term
Liabilities Current Term
Net Worth (Equity)
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Balance Sheet

• Date is critical
• Snapshot of the financial health of a business at
  a point in time
• Provides information regarding questions of net
  worth, debt and assets

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Balance Sheet
Beginning Balance Sheet
Ending Balance Sheet
Liability
Liability
Asset
Asset
Equity
Equity
Profit
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Financial Fact
Gross Income Expenses Net Income Family
Withdrawals Change in Net Worth
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Financial Feat Increasing Net Worth
Gross Income Expenses Net Income Family
Withdrawals Change in Net Worth
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Balance Sheet
Beginning Balance Sheet
Ending Balance Sheet
Liability
Income Statement
Liability
Asset
Asset
Revenue - Expense Net Income
Equity
Equity
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Income Statement

• Looking at a period of time (1 year)
• Important to distinguish between
• cash inflow and outflow
• Income and expenses
• Helps manage production, finance and marketing
• Provides information on productivity

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Financial Statements

• Aid in tracking progress toward goals
• Provide information for making decisions which
  promote achieving goals

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Ratio Analysis

• Return on assets
• ROA (Net income Interest) / Total Assets
• Return on Equity
• ROE Net income / Total Equity
• Leverage the relationship between ROA and ROE

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• Relationship Between ROA ROE

Return on Equity
D/A .5 i 10
D/A 0
.15
.10
.05
Return on Assets
-.10
-.05
-.15
.10
.15
.05
-.05
-.10
-.15
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Cost Concepts

• Fixed and Variable Costs
• Cash and Non-cash Costs
• Sunk Costs

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Fixed and Variable Costs

• Fixed Costs - those not affected by how much an
  asset is used.
• Variable Costs - those which are proportional to
  how much an asset is used.

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Fixed Costs

• Cost per unit of output decreases as quatity of
  output increases
• DIRTI 5
• Depreciation
• Interest
• Repairs
• Taxes
• Insurance

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Variable Costs

• Cost per unit of output remains constant with the
  quantity of output.
• Examples
• Feed
• Veterinary and Medicine
• Fuel
• Labor

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Which of the following costs are fixed and which
are variable?

• Purchased Feed
• Repair on Equipment
• Maintenance of Buildings
• Bull Purchase
• Vaccinations

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Average Fixed and Variable Costs
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Total Fixed and Variable Costs
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Cash and Non-cash Costs

• Cash Costs - costs incurred when inputs are
  purchased for production
• Examples
• Wages
• Purchased Feed
• Fuel
• Supplies

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Cash and Non-cash Costs

• Non-cash Costs - implicit costs which do not
  require a present outlay of cash when the input
  is used.
• Examples
• Unpaid Family Labor
• Interest on Owners Equity
• Depreciation

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Sunk Cost

• A cost which has been incurred already.
• A sunk cost can be fixed or variable
• Depreciation is a fixed sunk cost
• Feed is a variable sunk cost once the feed has
  been fed.

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Necessary and Postponable Costs

• Necessary Costs - costs associated with essential
  functions
• Postponable Costs - costs which are critical but
  which may be postponed for a period in order to
  save a current cash outlay.

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Which of the following costs are necessary and
which are postponable?

• Purchased Feed
• Repair on Equipment
• Maintenance of Buildings
• Bull Purchase
• Vaccinations

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Partial Budgeting

• Additions
• Added Returns
• Reduced Costs

• Subtractions
• Added Costs
• Reduced Returns

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Partial Budgeting Examples

• Expanding or Contracting Herd Size
• Purchasing or Leasing Equipment
• Renting or Purchasing Additional Land
• Changing Technology
• Organic vs conventional production
• Compost vs fresh manure production

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Partial Budgeting and Liquidity

• Depreciation is no longer an added cost
• Interest is cash interest rather than an
  opportunity cost of interest
• Determine ability to make loan payments

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Partial Budgets and Risk

• Look at the worst case scenario
• Consider interaction with other enterprises
• Labor Demands
• Equipment Demands
• Long run or Short run Perspective
• Prices
• Life of Assets

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Risk

• I have seen something else under the sun The
  race is not to the swift or the battle to the
  strong, nor does food come to the wise or wealth
  to the brilliant or favor to the learned but
  time and chance happen to them all.
• Ecclesiates 911

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Sources of Risk

• Production Risk risk associated with having
  less than anticipated yield
• Price Risk risk associated with having less
  than a target price
• Financial Risk risk associated with having
  insufficient cash flow
• Legal Risk risk of liability
• Human Risk risk associated with human/employee
  judgement

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Economic Principle Risk Return Tradeoff

• Higher returns accompany higher risks
• Manage Risk - do not avoid risk
• Manage risk by
• Gathering pertinent information
• Taking safe decisions livestock futures
• Paying someone else to take the risk from you
  livestock options and other insurance

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Analyzing Decisions Accounting for Risk

• Define the possible states of nature
• Calving percent of 70, 80, 90
• Drought yields 1 ton hay, 2 tons, 5 tons
• Determine different actions to take
• Stocking rate
• Herd health
• Estimate outcomes associated with different
  actions given different states of nature.
• Make a choice

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Decision Making Criteria

• choose action with highest expected return
• ignore risk
• weighted for probability of outcomes
• mean-variance analysis - choose action a, if
  returna gt returnb and variancea lt varianceb,.
• Safety first (or maximin) choose action with
  highest minimum outcome
• Shoot for the Moon (maximax) choose action with
  highest maximum outcome

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Stocking Rate Example
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Stocking Rate Example
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Stocking Rate Decision
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Keys to Decision Making

• Major on the major
• Gather pertinent information
• Make a decision or plan
• Write out the plan
• Have someone keep you accountable to the plan

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Sources of Risk Production Risk

• Select low production risk enterprises
• Diversify business
• Maintain cost flexibility
• Use risk-reducing production practices
• Invest in extra machine capacity
• Diversify farm operation geographically
• Negotiate land lease arrangements
• Maintain resource reserves
• Purchase crop insurance
• Obtain additional information

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Sources of Risk Market Risk

• Hedge on futures market
• Insure using options market
• Sell by forward contracts
• Spread product sales over time
• Maintain product and harvest cost flexibility
• Select low-price risk enterprises
• Diversify business
• Negotiate land lease arrangements
• Forward price production inputs
• Obtain more outlook information

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Sources of Risk Financial Risk

• Keep adequate liquidity
• Maintain credit reserve
• Negotiate longer loan repayment periods
• Hold safe solvency position
• Develop land leasing strategies
• Incorporate to limit risk
• Obtain more accounting information

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Sources of Risk

• Technology Risk
• Maintain flexibility
• Keep informed of new developments
• Lease rapidly changing technology
• Legal Risk
• Maintain insurance program
• Keep informed on new regulations
• Hire custom and contract work

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Sources of Risk

• Human Risk
• Plan back-up management
• Plan for loss of an employee
• Maintain insurance program
• Plan for estate transfer
• Education and training