Working toward a more accurate farm financial analysis
An accurate farm financial analysis will help you understand your business and improve strategic decision making.
Each year, Michigan State University Extension farm business management educators work with farmers across the state to conduct farm financial analyses. This analysis allows farmers to better understand their businesses, including financial and production strengths and weaknesses.
Most of the farms that participate in this financial analysis are enrolled in MSU’s TelFarm financial record keeping program. The TelFarm program works with producers to ensure that they have complete, accurate records to use in decision making.
Through the completion of a good financial analysis, we can analyze whether the farm was profitable (Net Farm Income), its cash flow position, and determine changes in the farm’s net worth. These are often referred to as the “Big Three” measures of farm financial performance. Farms also receive financial performance indicators on 17 Financial Standards Measures (e.g. operating profit margin ratio, debt-to-asset, asset turnover). These indicate whether the farm business is strong, vulnerable, or weak in certain areas. This information not only helps you understand your business, but also is important for securing loans, and necessary for putting together a quality farm succession plan.
What do you need to complete a good farm financial analysis?
In order to complete a good farm financial analysis, you’ll need a few items. First, an accurate and complete accounting of the farm-related income and expenses is necessary (Income Statement). Depending on your accounting system, these may already be grouped into categories with subtotals. The TelFarm program supports two software packages, PcMars and QuickBooks Desktop. With both of these programs, a standard “chart of accounts” is provided for analysis consistency.
Second, you will need both beginning and ending balance sheets (e.g. 12/31/2019 and 12/31/2020 for a 2020 Farm Financial Analysis). Balance sheets provide a snapshot of the farm’s assets and liabilities. Examining two balance sheets allows us to determine the change in net worth. Net worth (sometimes called owner’s equity) is calculated by subtracting liabilities from assets.
Additionally, balance sheets also provide needed information to make accrual adjustments to the income statement. These adjustments make possible a true profit analysis based on the production year. Adjustments need to be made to the following:
- Quantities and value of inventory
- Value of growing crops (for inventory changes)
- Accounts payable and receivable
- Government payment adjustments for the correct crop year
- Loan interest
- Prepaid expenses
These adjustments ensure that only income earned from and expenses incurred to the year’s production are included. For example, only income and expenses to produce 2020’s production are included in the 2020 analysis.
Tips for improving your farm financial records
The quality of a farm’s financial analysis is largely dependent on the quality of bookkeeping. This is true even with good accounting software and assistance from professionals. If you want a good farm financial analysis that allows you to make informed decisions, you need to invest time and energy. Based on experience from the farms we have worked with, there are a few common issues that can be easily remedied. Following these tips will improve your farm records and ultimately the quality of your financial analysis.
First, you need an accurate recording of all FARM income and expenses. Ensuring such recording requires good communication between individuals buying items and the bookkeeper. These individuals also need to agree on how the expense or income should be entered into the accounting system. Note, farm income and expenses should be tracked in a separate bank account from personal income and expenses.
Second, reconcile your farm accounting software to the bank statement. If farm records are not reconciled, you cannot guarantee records are accurate. Without accuracy, how can you make decisions confidently?
Finally, we recommend that farmers verify and reconcile their loan statements with their records. This includes their loan’s principal and interest payments and balances at the end of each year. If there are differences between the statements and records, make adjustments as necessary.
With an accurate income statement and balance sheets, you can conduct a high-quality farm financial analysis. This analysis is critical for accurate and confident decision-making on the farm. This analysis is also a foundation to finding the farm’s cost of production by enterprise or production area.
With time and effort, as well as detailed records by enterprise, every farm can achieve an enterprise level analysis for even more strategic decision-making. In future articles, we delve into the biggest factors that affect farm profitability.