Farm Balance Sheet Analysis

1
Farm Balance Sheet Analysis

• AAE 320
• Paul D. Mitchell

2
Goal

• Overview accounting balance sheet as it pertains
  to agricultural operations
• How to prepare and/or read one
• How to use one (financial ratios)

3
Balance Sheet

• Systematic listing of everything owned and owed
  by a business/individual
• Gives statement of owner equity at a point in
  time
• Typically for end of accounting period, such as
  end of year for taxes
• Interim balance sheets often used/needed for loan
  applications

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Balance Sheet

• Balance sheet Everything must balance
• Asset anything owned
• Liability debt or financial obligation owed
• The Basic Accounting Identity must hold
• Assets Liabilities Owner Equity
• Owner Equity Assets Liabilities
• Equity is whats left, the residual

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Uses of Balance Sheet

• Measures financial position of firm, focusing on
  long and short run measures
• Solvency measures relative relationships among
  assets, liabilities and equity to assess health
  of firm (financial ratios)
• Liquidity measures ability to meet current
  financial obligations as they come due without
  disrupting normal businessability to generate
  cash on short-term

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Balance Sheet Format
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Assets

• Anything the firm owns that has value because can
  sell it and/or use it to produce sellable goods
• Liquid assets easy to sell, ready market for
  them (grain, feeder livestock)
• Illiquid assets hard to sell quickly at full
  value (machinery, land, breeding livestock)

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Assets on Balance Sheet

• Current Assets
• Cash, bank accounts, marketable funds, accounts
  receivable (money owed to you), inventories of
  liquid assets grain, feed, supplies, feeder
  livestock
• Non-Current Assets
• Everything else machinery, equipment, breeding
  livestock, buildings, land

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Liabilities on Balance Sheet

• Obligations or debts owed any outside claims
  against one or more of your assets
• Current Liabilities
• Financial obligations due within 1 year
• Accounts at suppliers, farm store, etc.
• Interest principle on operating and long-term
  loans
• Accrued expenses property and income taxes
• Non-Current Liabilities
• Everything else not due in the next year
• Remaining balance on long-term debts after
  deducting the current years payments

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Alternative Balance Sheet Formats

• Traditional farm balance sheets used other
  categories, but use decreasing
• Intermediate Asset less liquid with life 1 to 10
  years (machinery, equipment, perennial crops,
  breeding livestock)
• Fixed Asset gt 10 year life land, buildings
• Intermediate Liability 1 10 year loans
• Long-term Liabilities gt 10 year loans

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Owner Equity Net Worth

• Value left after assets are used to cover all
  liabilities, what you own in the farm
• Your current investment in the farm
• Equity changes for many reasons
• Profits/losses from production activities
• Sell assets for different values than on sheet
• Add/withdraw capital from the farm
• Asset value changes if use market prices for
  asset valuation, e.g., land value increases

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Owner Equity Net Worth

• Business transactions only change the mix of
  assets/liabilities, not owner equity
• Buying a 10,000 piece of machinery does not
  change your equity
• If cash purchase, current assets drop 10,000 and
  non-current assets increase 10,000
• If borrow 10,000, liability increases 10,000
  and non-current assets increase 10,000
• Equity only changes due to business profit/loss,
  if you put money in/pull it out, and/or (in some
  cases) if asset values change

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Asset Valuation Problem

• How do you value assets when developing a balance
  sheet, Cost or Market Basis
• Basic accounting says use cost basis, but not
  always right in agriculture
• Cost Basis value purchase cost minus
  depreciation, or farm production cost
• Market Basis value current market value minus
  selling costs

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Market Basis

• Assets valued at current market value minus
  selling costs
• Asset value (and so your equity) responds to
  inflation and price changes, so often gives
  higher values (and so higher equity)
• Asset price changes can hide management problems
  because equity increasing
• Main Advantage more accurate measure of current
  financial health and collateral available for
  loans, so often used by lenders
• Lenders needs influence farm balance sheets

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Cost Basis

• Asset value purchase cost minus depreciation,
  or cost to produce the asset
• More conservative, following accepted accounting
  practices in other businesses
• Equity changes only from retained earnings, not
  from asset price changes
• Can misrepresent true value of business

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Farm Financial Standard Committee

• Recommends using both methods
• 1) Market basis balance sheet with cost basis
  asset values in attached schedules or in
  footnotes
• 2) Double Column balance sheet for assets, with
  market basis and cost basis
• Measure true value market of your business and
  identify possible management problems

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Both Methods use Both Methods
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Grain/Livestock Inventories and Crops in the
Fields

• Grain in the bin, animals on the lot ready to go,
  use market basis
• Exception Purchased grain/livestock that has
  gone up in value, use cost if on a cost basis
• Crops still growing in the field, use cost, since
  still subject to production risks
• Dont count your chickens before the eggs hatch

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Raised Breeding Livestock

• Cost basis supposed to accumulate all costs to
  get the animal from birth to productive age (and
  not include these in the income statement), then
  depreciate this total cost over its useful
  lifetime just as though purchased it at this
  price
• Alternative a fixed base value for each age/type
  of animal to approximate this cost and its
  depreciation, wont change with asset market
  prices

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Depreciation

• Annual loss in value of a working asset due to
  use, wear, aging, and technical obsolescence
• What assets due you depreciate?
• Useful life gt 1 year
• Useful life can be determined (not unlimited)
• Machinery, equipment, buildings, fences, breeding
  livestock, perennial crops, irrigation wells,
  land improvements (wells, drainage)
• Land not depreciated, as has unlimited life

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Depreciation Definitions

• Cost All costs paid for the asset, including
  price, taxes, delivery and installation fees,
  expenses to get the asset into use
• Useful Life Number of years you expect to use
  the asset in your business
• Salvage Value Expected market value at end of
  useful you assigned zero if you will use it
  until worn out and has no scrap or junk value at
  end

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Depreciation Intuition

• Want to allocate the initial cost of long term
  asset across the useful life you give it
• Cost Salvage Value is assets total
  depreciation over its Useful LifeHow much do you
  assign to each year?
• Several formulas make assumptions and estimate
  annual depreciation, none is correct for all
  assets in all situations

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Graphics of Depreciation
Total Depreciation to Allocate
Value ()
Initial Cost
Salvage Value
Time (Years)
Useful Life
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Graphics of Depreciation
Use a mathematical formula to describe how to get
from Point A to Point B Slope of the line between
any two years is the annual depreciation during
that year Depreciation DValue/Dt
A
DV
Value ()
Dt 1
B
Time (Years)
One Year
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Straight Line Depreciation

• Draws a straight line between beginning and
  ending values, constant depreciation each year
• Annual Depreciation
• (Cost Salvage Value)/Useful Life
• Alternative Express as a depreciation rate
• Annual Depreciation
• (Cost Salvage Value) x RSL
• RSL 1/Useful Life Depreciation Rate
• Example RSL 1/10 0.10 10
• 10 annual depreciation rate

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Straight Line Depreciation Example

• 100,000 machine, use for 6 years and expected
  salvage value of 40,000
• Annual Depreciation
• (100,000 40,000)/6 10,000
• RSL 1/6 0.167 16.7
• Annual Depreciation
• (100,000 40,000) x 16.7 10,020

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Straight Line Depreciation Example
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Sum of the Years Digits

• Annual Depreciation
• (Cost Salvage Value) x RUL/SOYD
• RUL Remaining Useful Life at START of year
• SOYD sum of the years digits from 1 to Useful
  Life
• Example Useful Life 6 years, then
• SOYD 1 2 3 4 5 6 21
• SOYD n(n 1)/2, where n Useful Life
• Largest depreciation in first year, constant
  decrease in depreciation for each year after that

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Sum of the Years Digits Depreciation Example

• 100,000 machine, use for 6 years and expected
  salvage value of 40,000
• SOYDs 1 2 3 4 5 6 21
• Annual Depreciation
• (Cost Salvage Value) x RUL/SOYD
• 1st Year (RUL at start 6)
• (100,000 40,000) x (6 0)/21 17,143
• 2nd Year (RUL at start 5)
• (100,000 40,000) x (6 1)/21 14,286

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SOYD Depreciation Example
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SOYD Depreciation Example
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Think Break 12

• You buy a piece of equipment for 7000 with a
  useful life of 3 years and expected salvage value
  of 1000
• 1) What is the Straight Line depreciation for the
  second year?
• 2) What is the Sum of the Years Digits
  depreciation for the second year?

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Declining balance

• Depreciation constant percentage of the assets
  current basis
• Not (cost salvage value)
• Depreciation Beginning Basis x RDB
• RDB Declining Balance Depreciation Rate
• Declining Balance value of depreciation
  decreases each year, though constant
  depreciation rate

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Declining Balance

• Declining Balance Depreciation Rate RDB usually a
  multiple of the Straight Line Depreciation Rate
  RSL 1/Useful Life
• RDB 2 x RSL, is Double Declining Balance or
  200 Declining Balance
• Also see 1.75/175, 1.50/150 and 1.25/125
  declining balance
• Depreciation for taxes uses declining balance

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Double Declining Balance Example

• 100,000 machine, use for 6 years and expected
  salvage value of 40,000
• Double Declining Balance depreciation rate
• RSL 1/6 16.67
• RDB 2 x RSL 2/6 2 x 16.67 33.3
• 1st Year DDB Depreciation is
• 100,000 x 1/3 33,333

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Double Declining Balance Example
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Double Declining Balance Example
Problem Basis can fall below salvage value
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Potential Problems with Double Declining Balance

• Assets with positive salvage value, basis can
  fall below salvage value
• Stop depreciation at salvage value
• Assets with zero salvage value, basis never
  reaches zero
• Switch to straight line after some set time
• Take remaining value in last year

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Double Declining Balance Example(Salvage value
40,000)
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Compare the Three

• Straight Line Depreciation
• Slowest depreciation Finishes at the salvage
  value without any adjustments
• Sum of the Years Digits
• Medium rate of depreciation Finishes at the
  salvage value without any adjustments
• Declining Balance
• Typically fastest (specially DDB) Often has to
  be adjusted to finish at the salvage value

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Depreciation Graphics
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Asset Value Graphics
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Think Break 13

• Machine costs 7000 with a useful life of 3 years
  and salvage value of 1000
• 1) What is the double declining balance
  depreciation for the 1st year?
• 2) What is machines ending basis in 1st year?
• 3) What is the double declining balance
  depreciation for the 2nd year?
• 4) What is machines ending basis in 2nd year?

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Depreciation and Taxes

• US tax code has rules and options for
  depreciating business assets, including those
  used by farmers
• MACRS Modified Accelerated Cost Recovery System
• Three methods used 200 DB, 150 DB, and
  Straight Line
• Depends on asset type
• Sometime you get to choose

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Depreciation and Taxes

• Determine assets basis (called tax basis)
• Basis adjusted for several reasons, such as
  improvements made, damage, etc.
• Calculate depreciation as a of tax basis
• taken from a table
• Tax tables assume zero salvage value
• Deduct depreciation from your taxable income (so
  you pay lower taxes!)
• Tax basis ? true value or your book value

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Depreciation and Taxes

• Section 179 Allows taking a large amount of
  depreciation in year purchase asset
• Way to really reduce income (and so taxes)
• Buy equipment/building and write full cost off as
  a cost of business in that year
• The ending basis of asset is zero in first year
• Many farmers do this in years they make more
  money than usual

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Depreciation and Taxes

• Depreciation Recapture Form 4797
• When sell an asset, if the sales price differs
  from the tax basis, file Form 4797
• If sale price gt tax basis claim extra as
  ordinary income and pay income taxes
• If sale price lt tax basis claim extra
  depreciation and reduce ordinary income and
  income taxes
• Eventually the government gets its taxes if you
  over depreciate an asset via Section 179

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Depreciation and Taxes

• Main Point Tax depreciation not the same as
  real depreciation
• Section 179 depreciation really throws it off
• Businesses farms some keep separate records
• Tax depreciation and tax basis records
• Book value for farm balance sheet for farms
  real value for loan applications
• Records of asset values for insurance purposes
• Can create complicated farm records

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Summary Thus Far

• Explained concept of a balance sheet
• Current and Non-current Assets
• Current and Non-current Liabilities
• Equity what balances the sheet
• How value Assets cost or market basis
• How depreciate assets straight line, sum of
  years digits, double declining balance
• Taxes and depreciation
• What do you do with a balance sheet??????

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What use is a Balance Sheet?

• Can see where assets and liabilities are and
  their relative sizes
• Can look at changes if have balance sheets from
  previous yearssee if youre gaining
• Typically focus on ratios to look at Liquidity
  and Solvency of the business
• Ratios control for differences in business size

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Current Ratio and Liquidity

• Measures ability to meet current financial
  obligations as they come due without disrupting
  normal businessability to generate cash on
  short-term
• Current Ratio
• Current Assets/Current Liabilities
• Example 1.4 or 40

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Current Ratio

• Too low cash flow problems, if asset prices
  change or costs suddenly arise (repairs), can
  have trouble meeting current liabilities
• Dont want to sell 10 acres to put new roof on
  barn
• Too high holding too much cash, current assets
  typically have lower return than if put capital
  into other longer term assets or market
• Income lost by keeping cash under the mattress
• Parable of the talents buried gold in ground

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What are typical current ratios?

• IL Farm Business Farm Management Program of 2,166
  IL farms in 1996
• Fairly typical by farm types
• Farm Type Median Current Ratio
• Hogs 2.03
• Grain 1.81
• Beef 1.57
• Dairy 1.33

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Whats a good Current Ratio?

• Iowa State University Extension
• Typically farms with adequate liquidity have
  current ratios gt 2.0
• Farms with continuous sales (dairy) often have
  current ratio as low as 1.5
• Beef feeding farms have low current ratios
• Farms with concentrated sales (cash grain) need
  current ratio as high as 3.0 early in year
• Ohio State University Extension Measures of
  Dairy Farm Competitiveness 1.3 is competitive

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Working Capital vs Current Ratio

• Working Capital older term used by some
• Working Capital
• Current Assets Current Liabilities
• Measures the margin of safety in dollars (not
  ratio or ) to meet short-term liabilities
• Must relate it to size of business, thats why we
  use current ratio!
• 10,000 not much for a 5000 acre farm, but may be
  more than enough for a 20 cow dairy
• This why most use current ratio

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Solvency

• Measures relative relationships among assets,
  liabilities, and equity to assess health of
  firm
• Could the farm debt be paid off if foreclosed?
• Requires Assets gt Liabilities
• Measured by three ratios
• Debt to Asset Ratio
• Equity to Asset Ratio
• Debt to Equity Ratio
• Given any one ratio, you can derive the others,
  so each is a different way to look at Solvency

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Debt to Asset Ratio

• Debt/Asset Total Liabilities/Total Assets
• Proportion (or ) of business assets owed to
  lenders (i.e. the bank owns)
• 0.70 means you owe 70 of farm assets to lenders
  (bank owns 70)
• 1.0 means debts assets
• Means owner equity is zero, bank owns 100
• gt 1.0 means business is insolvent

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Equity to Asset Ratio

• Equity/Asset Total Equity/Total Assets
• Proportion (or ) of assets owned
• 0.45 means you own 45 of farm
• 1.0 means equity assets so owner has no
  liabilities (he/she owns all equity)
• Own 100 of the farm
• lt 0 means business is insolventhas no or
  negative equity

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Debt to Equity Ratio

• Debt/Equity Total Liabilities/Owner Equity
• Proportion of financing provided by lenders
  relative to that provided by owner equity
• 1.0 means you and your lenders are providing
  equal proportion of financing
• 0.75 means for each dollar of equity financing
  you provide, your lender provides 0.75 of
  financing
• 1.8 means for each dollar of equity financing you
  provide, your lender provides 1.80 of financing
• Very large Debt/Equity ratio implies very small
  equity and potential for insolvency

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Relation between Ratios

• Given any of these three financial ratios, you
  can derive the others
• Basic Accounting Identity must hold
• Assets Liabilities Equity
• Assets Debts Equity
• Notation A D E
• Debt/Asset D/A
• Equity/Asset E/A
• Debt/Equity D/E

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Relation between Ratios

• A D E Divide by A 1 D/A E/A
• Debt/Asset Equity/Asset 1, or
• Equity/Asset 1 Debt/Asset
• Debt/Asset 1 Equity/Asset
• (D/A)/(E/A) D/E, or
• Debt/Equity Debt-to-Asset/Equity-to-Asset
• Rearrange and use D/A and D/E connection
• Debt/Asset Debt/Equity/(1 Debt/Equity)
• Equity/Asset 1/(1 Debt/Equity)

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Typical Solvency Ratios

• IL Farm Business Farm Management Program of 2,166
  IL farms in 1996
• Debt to Asset Ratios
• Farm Type upper 25 Median lower
  25
• Hogs 0.44 0.30 0.16
• Grain 0.46 0.29 0.15
• Beef 0.52 0.31 0.17
• Dairy 0.50 0.36 0.23

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WI Center for Dairy Profitability WI Dairy
Balance Sheet for 2000
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More Information

• Provide a quick list/overview of what sort of
  information is available on farm finance
• Farm Financial Standards Council
• University Extension UW and other states
• UW Center for Dairy Profitability

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Farm Financial Standards Council

• Home page http//www.ffsc.org/index.html
• Mission To provide education and a national
  forum to facilitate the development, review,
  communication and promotion of uniformity and
  integrity in both financial reporting and the
  analytic techniques useful for effective and
  realistic measurement of the financial position
  and the financial performance of agricultural
  producers.
• Financial Guidelines for Agricultural Producers
• http//www.ffsc.org/html/guidelin.htm
• Recommendations of how to prepare Farm Financial
  Balance Sheet with several examples
• The source for this sort of information

69
UW-Extension

• Bruce Jones (AAE, UW-Madison) Focuses on dairy
  farm management and land valuation
• See his home page for most recent papers and
  presentations http//www.aae.wisc.edu/jones/
• Gregg Hadley (Ag Econ, UW-Riverfalls) focuses on
  dairy farm management profitability and finance
• http//www.uwrf.edu/extension/GreggH.htm
• Both work with UW Center for Dairy Profitability

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UW Center for Dairy Profitability

• Homepage http//www.cdp.wisc.edu/
• Focuses mostly (not exclusively) on dairy
• Lots of materials, some financial
• WI dairy data as Farm Balance Sheets for
  comparison and benchmarking
• http//www.cdp.wisc.edu/Financial20Benchmarks.ht
  m

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Neighboring States

• Center for Farm Financial Management
• http//www.cffm.umn.edu/
• Sell/Support FINPACK The most comprehensive
  computerized farm financial planning and analysis
  system available

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Neighboring States

• Iowa State University AgDecision Maker
• http//www.extension.iastate.edu/agdm/homepage.ht
  ml
• University of Illinois FarmDoc
• http//www.farmdoc.uiuc.edu/
• Both have sections on Farm Finance with several
  publications and decision aids

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Non-Neighboring States

• Oklahoma State University
• Damona Doyes web page
• http//agecon.okstate.edu/faculty/profile.asp?id
  ddoye
• Farm Financial Management Resources
• http//agecon.okstate.edu/faculty/ffmr.asp
• Farm and Ranch Account Book
• http//agecon.okstate.edu/farmbook/

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Summary

• Explained balance sheet
• assets, liabilities, equity
• How to value Assets cost or market basis
• How to depreciate Assets straight line, sum of
  years digits, declining balance
• Ratios Current Ratio, DebtAsset, etc.
• How to construct and interpret
• Typical values by farm type
• Where to go for more information