Many producers do not know exactly what it costs to produce one unit of product. They know their whole-farm expenses and income, they know their profit margins (income minus direct expenses), but rarely do they segregate all costs of the business (including indirect costs) into the responsible enterprises. Direct costs are those easily identified with the production of a specific commodity (i.e., feed purchased for weaned kids). Indirect costs are those that cannot be easily identified with the production of a specific commodity (i.e., farm utilities, land rental and property taxes). The commodities sold by the farm business are responsible for paying all costs associated with their production, including direct and indirect costs. Only when all business costs are “absorbed”, can producers identify the enterprises that are making or losing money.

A farm business usually has several enterprises that produce commodities for sale. To manage the business, each enterprise should be evaluated separately with its production costs “matched” to the income it produces. These enterprise budgets show that the commodities sold are responsible for paying their share of the farm business expenses. For goat producers, goats are the primary commodities sold by the business, but they may be represented as different enterprises, i.e., an enterprise that sells weaned market kids or an enterprise that sells slaughter weight wethers or breeding stock does that take longer to produce.

Many of the farm’s business activities are based on financial records and business transactions. A transaction is an exchange of resources. An expense transaction occurs when a farmer gives a resource (i.e., money) in exchange for another resource (i.e., feed, labor, breeding does, or a tractor). The resources gained by the farmer (i.e., feed, labor, does, or a tractor) are necessary inputs to producing the commodity (i.e., weaned kids). Some of the resources will be used in the current growing season (i.e., feed and labor) while some will be used over time (i.e., does and the tractor) and depreciated. Other resources, although used, are not expended (i.e., land). The farm family should have a separate checking account for personal (non-business) transactions. However, this is not practical for many small farmers. Because the family depends on the income from the farm to pay for many of their living expenses, “pay” family members according to the work that they do on the farm (i.e., record their labor, accounting, secretarial, and management wages). By “paying” family members who help with the farming operation, your enterprise budgets will be more accurate.

Farm business transactions can be classified:

1. By enterprise,
2. As Cash or Non-cash transactions,
3. As Cash Inflow or Cash Outflow transactions on the Cash Flow Statement, or
4. As transactions that apply to the Income Statement or Balance Sheet.

First, we will discuss the types of financial business statements and why they are important to the farm business. Financial statement analysis helps to identify the farm’s financial strengths and weaknesses and to identify strategies for the future. Comparing the farm’s business to its past performance each year will help you to determine the health of the farm business, whether the business is growing or shrinking financially, and how the change is occurring. At a minimum, the financial statements that are used for financial analysis are:

1. Beginning and Ending Balance Sheet – the balance sheet reports the financial position of the farm business on a specific date and summarizes the business’ assets, liabilities, and the owner’s equity,
2. Income Statement which summarizes the farm business’ income and expenses for a period of time (a year) and measures the profit of the business, and
3. Cash Flow Statement which shows the monthly flow of money through the farm business.

Later, we will use example farms to show a method to allocate the farm business transactions to the different farm enterprises and how to fit the transactions into the financial statements.

Cash Flow Statements

Cash Flow Statements tell the farmer when, and from where, the farm received cash and how and when the cash was spent. It is a valuable tool for planning that a farmer needs to complete and analyze each year. The cash flow statement shows the farm business’s monthly cash receipts (cash inflows, such as weaned kid sales) and cash purchases (cash outflows, such as purchased feed). It helps the farmer to predict and plan for the months when cash is short (the cash inflow will not cover the expenses) and months when cash is sufficient (the cash inflow can cover the expenses and when excess cash is available to purchase assets or repay loans). Creditors (including farm supply stores who carry bills and tabs) and lenders often require cash flow statements so they will know when loans can be repaid. This reduces their lending risk making them more willing to lend or run credit lines, and may lower the interest rate.

Cash flow statements can be records of past years’ performances or projected for future years or periods of time (this is often called “pro forma statements” by lenders). In either case, the cash flow statement:

1. Outlines the cash inflows coming into the farming operation, usually from sales of commodities or custom labor, that is available to the farm by account (description of the income) and by month;
2. Details the cash outflows (expenses) by account (description of the expense) and by month;
3. Shows months that have cash surpluses or deficits; and
4. Reconciles the beginning cash balance with the ending cash balance.

Income Statements

The Income Statement provides the farmer with a measure of the success of the business in terms of net income or loss for a specified period of time, usually one year. The Income Statement (also called a Profit and Loss Statement) tells the farmer that from January to December how much money was earned and how much was spent to earn it.

Income Statements by Enterprise breaks the income and expenses down by the responsible enterprise so that each commodity can be individually evaluated. Groups of income and expenses are called “accounts”. Accounts are descriptions indicating what type of income or expense is represented (i.e., weaned kid sales (income) or feed (expense)). This information can be used to calculate financial ratios that further evaluate the farm business’ performance. Most lenders want to see the previous year’s income statement to determine the farm’s credit worthiness prior to making a loan. The Income Statement is a progress report of the farm business. The net income or loss for the business tells the operator whether or not the business is moving towards fulfilling the farm’s goals. Over a period of years, the income statements can tell the operator whether the business is going up or down and help the farmer to determine which enterprises are contributing to the profits or which are taking profits away.

Income accounts are presented first on the income statement. These include the sale of goats, custom work that you did for others, dividends from cooperatives, and other income sources. Expense accounts are presented below the income accounts. These include feed, fuel, labor, and other costs. The income statement also includes expenses that are not paid in cash such as depreciation. This is management depreciation that differs from tax depreciation by using the straight-line method which expenses the cost of an asset over its useful life. For example, a purchased tractor that is expected to be used for 15 years is depreciated as (purchase price/15) rather than the accelerated tax depreciation method. The straight-line method, which is determined based on the asset’s useful life, is a better choice for management depreciation. Once all income and expenses have been identified, the farmer can determine if the enterprise or farm business is profitable.

Accrual Adjustments

Although most farmers use the cash basis in their records and reports, accrual adjustments often give a more complete record of the farm business. What are accrual adjustments (instead of cash), and how do they relate to the income statement? Accrual adjustments are necessary temporary adjustments made so that the income and expenses are “matched.” In order to evaluate a specific enterprise, the production cycle must be complete (i.e., kids are weaned and ready for sale). The income and expenses are for that production cycle and enterprise. An example of an accrual adjustment is feed that has been fed to kids but has not been paid for. The amount owed should be included in the current year expenses. When the feed debt is paid the following year, the accrual will be “reversed” by subtracting the accrual amount (the previous year’s cost) from the cash transactions which occurred in the following year when the bill was paid. If the accrual is not reversed, the expense will be double counted.

Other examples of accrual adjustments are: 1) depreciation, 2) income earned but not received (deferred income), 3) income received but not earned, 4) prepaid expenses, 4) accounts payable, 5) accounts receivable, and 6) inventory changes. In short, if the input has been used, it should be expensed whether or not it has been paid for. If the income has been earned (i.e., weaned kids were sold) or the purchased item was paid for (i.e., goat handling pen was paid for), it should be included in the current year whether or not the payment or purchase has been received. The farm manager needs an accrual-adjusted income statement to know the enterprise’s true profitability. To figure accrual adjustments for prepaid expenses use:(beginning inventory) + (purchases) – (ending inventory) = (amount used during the year).

Balance Sheet

The Balance Sheet is a snapshot of the farming operation.

1. It outlines the assets (what is owned).
2. It summarizes the liabilities (what is owed to somebody else).
3. It establishes equity (what is owned free and clear after the liabilities are paid).

What is a balance sheet? The balance sheet shows what the operation owns and what it owes. The amounts reported are a running balance of transactions from the beginning of the operation up to the date specified. For example, an operation purchased a livestock trailer for $10,000, but still owes $4,000 on the trailer. In the top section of the balance sheet, the total amount purchased is reported in the assets section ($10,000) and the amount owed is reported in the liabilities section ($4,000) at the bottom. The “net” amount that the business owns is $6,000. The business has equity of $6,000.

Who needs a balance sheet and why? Lenders are very interested in the balance sheet. They primarily want a business to repay the loan, but if there is an instance when repayment is not made, the lender wants substitute compensation or collateral. When a business is “over-leveraged,” its equity is small. The percentage of ownership in the business is too small, and therefore the loan is more risky. The lender may deny the loan or may increase the interest rate as their compensation for accepting more risk. Farm managers use the balance sheet to analyze the financial health of a business and for planning strategies for the farm business. Having a balance sheet is good business management.

The balance sheet lists the farm’s assets, liabilities and equity. Assets and liabilities are broken into current and non-current.

1. Current assets are those items that can be turned into cash rapidly (within the next twelve months) such as a checking account, feed inventories, feeder livestock, or raised crop inventories.
2. Non-current assets (sometimes referred to as intermediate and long term assets) are those items that are used for production and cannot be readily sold. They include breeding livestock, machinery and equipment, buildings and real estate.
3. Current liabilities are debts that must be paid within twelve months. These could include accounts payable such as a feed bill at the feed store. In addition, the current portion of non-current liabilities should be included in the current liability section. This would include any payments on non-current debt that is due during the next twelve months.
4. Non-current liabilities are debts that do not come due within the next twelve months. These would include land payments, mortgages, etc.
5. Once the total assets and liabilities have been detailed, the producer can determine his net equity. Remember that equity is calculated as total assets minus total liabilities.

Value of Operation Assets

There are two methods used to value the assets of an operation. The first method is based on the “historical cost”, or purchase price of the asset (i.e., livestock trailer). The second method is the fair market value, or the price that would be paid for the asset (i.e., livestock trailer) if it were sold today. Although lenders will want to see a balance sheet based on the fair market value, the producer should always keep the balance sheet based on the historical cost. When a lender requests a balance sheet, the producer should add the fair market value of the asset to the balance sheet. Assets that are valued based on their historical costs should be listed and valued as: the purchase price minus its accumulated depreciation.

Some assets are raised, such as breeding and replacement does. The historical cost value of the doe is the accumulated expenses (costs) incurred to get her mature enough to breed. Annual operating expenses, such as feed, after she is able to produce are included in the annual business expenses for the period.

Review Questions (True or False)

1. The income statement reflects a “running balance” of items owned or owed as of a certain date.

   False. The income statement tells about the net income resulting from operations within a specified range of time. The balance sheet tells about what a business owns or owes (% ownership) as of a certain date (running balance).

2. The income statement should reflect all cash purchases during the year.

   False. The expense portion of the income statement should reflect the inputs actually used in producing the income reflected. The unused portion of inputs purchased (i.e., extra feed) should be held in inventory on the balance sheet. Likewise, purchases of assets, like machinery, should not be included as an expense; rather, the purchase amount should increase the balance of the non-current asset section of the balance sheet and the related current management depreciation should be included as an expense for the year.

3. Note payments are considered an expense.

   False. The principle portion of the payment reduces the balance of the corresponding liability (debt) on the balance sheet, and the interest portion only is included on the income statement as an expense.

4. The balance sheet tells a producer his net income.

   False. The Income Statement tells a producer about the net income. The balance sheet tells the producer about his ownership and equity in the business.

5. The entire purchase price of a tractor should be reflected as an expense (in the income statement).

   False. The cost of the tractor is expensed over its useful life and is noted as a depreciation expense.

6. The Cash Flow Statement provides information about the timing and nature of all cash inflows and outflows of a farm business.

   True. The Cash Flow Statement details the nature of cash inflows and outflows by account. Further, it summarizes by month each account’s transactions.

7. Cash Flow Statements can be either historical or projected (pro forma).

   True. Managers should produce both historical and projected (pro forma) cash flow statements.

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