Lessons learned from the 2019 season part 1

This article will focus on the importance of farm's financial status. Understanding the process of determining how well your farm is doing.

A field on a sunny day

The 2019 growing season will likely be looked on as a year most producers want to forget. As extreme weather impacted spring planting, overall growing conditions and even harvest, there were plenty we’d like to forget.  Unfortunately, the reality is that these conditions could occur again. As we turn the calendar to 2020, we should take time to consider lessons learned from this past year and how we can use them to better prepare against similar situations in the future.

One of the most important takeaways from 2019 was that we were collectively unprepared. We simply were not ready for the tremendous amount of rainfall and wet conditions that we faced at the start of the planting season. This situation left many farms trying to quickly understand what their best options were, and which option met their needs. The factors that go into those decisions serve as a road-map and guide on how to better prepare for these types of situations. Let’s take a look at the stops along that road-map:

Stop One: Importance of Farm’s Financial Status

The first place to start is to understand that each farm was at a different place financially when the rain started to fall.  Some farms opted to plant as many acres as they could.  Others took advantage of their crop insurance policies and left many fields untouched. Despite how different the choices were, they all had one central theme in common, “What option gave the best opportunity to make enough revenue to cover expenses?” 

The answer to this question was different for each farm. One key difference was that some farms were working through this year’s expenses and some of last year’s as well. Unpaid bills that remained from losses in recent years still loomed over many producers and affected their decisions. It was a difficult scenario of trying to cover all of those expenses or not have significantly more unpaid bills going into the next year. 

As we look to move into 2020, there will undoubtedly be more farms trying to weigh through this same situation. It is important that each farm understands where their financial starting point is for the 2020 year. To achieve this, MSU Extension recommendations conducting a financial analysis using the farm’s records.

Farm records are routinely thought about for two reasons: for managing income taxes or for getting a farm loan. When a tax return is prepared, it focuses on cash income and expense transactions within a calendar year. However, that doesn’t necessarily reflect all of the financial activities that happened for the production year. The financial picture is incomplete. 

Let’s look at an example farm:

   Cash Income $150,000
-  Cash Expense $110,000
-  Depreciation $10,000
= Schedule F Income   $30,000

Looking at this farm’s IRS tax return, did they make or lose money? According to the tax return the answer is yes, but did the farm really make $30,000? What about adjustments for crops stored in the grain bin, both at the beginning and end of the year? Some of those bushels weren’t part of the year’s production, but were part of the year’s cash transactions. This is where a financial analysis starts to put the pieces together and show the whole picture for a farm. 

Let’s take another look at the previous example and start to add in all the components of a financial analysis.

   Cash Income $150,000
-  Cash Expense $110,000
-  Depreciation $10,000
= Schedule F Income $30,000
-  Beginning Inventory (Crops in bin) $45,000
+ Ending Inventory (Crops in bin) $5,000
= Net Change (Subtracted from income) - $40,000
   Net Farm Income (NFI) - $10,000

The changes from grain inventories between the beginning and end of the year can be thought of as changes to the farm’s income. Instead of $150,000 in cash income, the actual income level would be closer to $110,000. However, to better track these adjustments in a financial analysis, the “net change” between inventories is made against the overall net farm income.  In this example, changes in inventories results in the farm to have experienced a loss of $10,000. 

There are similar adjustments for other activities on the farm. For example, what is the impact of pre-paid expenses that were purchased?

   Cash Income $150,000
-  Cash Expense $110,000
-  Depreciation $10,000
= Schedule F Income $30,000
    Beginning Inventory (Crops in bin) $45,000
    Ending Inventory (Crops in bin) $5,000
=  Net Change (Subtracted from income) - $40,000
     Beginning Pre-Paid Expense (Seed & chems) -  $10,000
     Ending Pre-Paid Expense (Seed & chems) +  $25,000
=   Net Change (Subtracted from expenses) + $15,000
      Net Farm Income (NFI) $5,000

Pre-paid expenses can be thought of as changes to the farm’s total expenses for the year. The purchase of $10,000 was made in the previous year, but was intended for this year’s production. While purchases of $25,000 were made at the end of this year, but are for next year’s production. This means that the net change is $15,000 less expense for the year than what was reported in the checkbook. 

The true (or accrual) net farm income is then $5,000, which is far less than the $30,000 shown on the IRS tax return. This significantly changes how much the farm actually has in a “typical year” to make loan payments, pay taxes and possibly make additional purchases. It also highlights the importance of maintaining accurate balance sheets, which often hold the information for a farm’s inventories, pre-paid expenses and other potential adjustments to net farm income.

This is why well-kept farm records are so critical. Using all of the information and not just the cash transactions in a financial analysis gives the whole picture for the production year  It adds in the missing pieces not seen on an IRS tax return and a detailed explanation of the farm’s financial status.

Knowing where the farm is financially becomes the foundation for you to begin making better-informed financial decisions. This also leads to the next stop on our roadmap: Cost of Production.

To find out more information and get a complete copy of the article series, you can visit here at the MSU Extension Farm Management Resources page.

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