Do you recall the last sporting event you attended? Upon seating yourself on the bleachers, the questions start. What is the score? Who is ahead? What inning is it? How much time is left? Who is winning? Without a scoreboard, those questions are difficult to answer.
The financial statements of ag businesses are nothing short of the “farmer's scoreboard” in a real-life game of ag production.
Let’s define the essential financial paperwork of a modern farm or ranch business – the balance sheet, a profit and loss recap and a cash position – and what those financial documents indicate about the business. Not having these financial statements updated frequently for reference is akin to attending a sporting event without a scoreboard.
The fans of a sporting event with no scoreboard would be much less, if at all, aware of what is going on. Similarly, the players in the sporting event with no scoreboard will be ill-equipped to perform to their best level of expertise or capabilities. So how do we utilize these financial scoreboard statements to manage a farm or ranch business to our best level of expertise and capability?
It's not just farming and ranching
As we step forward to answer this question, let me define a couple of parameters. Ag production today is not just farming and ranching. It is the operation of a complex and multifaceted business. This intricate business produces food (farming) and fiber (ranching). The industry feeds, clothes and, in some cases, shelters us. The farmers and ranchers in this complex business need to be businessmen and women first, and producers second. My contention (to be fully explained in another article) is that we lost many of our marginal ag producers in the '80s, and I fear that the remaining marginal ag businesspeople will struggle unduly throughout the 2020s and beyond.
To combat this struggle, the ag businessperson today must pay attention to, and understand, the financial measurements of the business.
Cash position
The cash position statement can be as simple as a regularly balanced checkbook or as complex as a CPA-prepared "Changes in Cash Position" statement. Notwithstanding the document format, it should tell the ag businessperson what cash has been used or spent and what cash is on hand to meet current obligations. Over time, this statement will indicate if the business is building or losing cash. It could also indicate how the expenses of the business are increasing or decreasing. This statement is a snapshot of the business at any given moment. By itself, the statement is limited in what it tells the businessperson, but it is certainly an important part of the scoreboard.
Profit and loss
The budget, or profit and loss reconciliation, is an indication of how well the business produces cash to meet its expenses, retire debt and pay owners. This document is less like a snapshot and more like a video taken over a specified period. This can be a month, a quarter or a year. Usually, this period is a calendar year, and most times, it coincides with tax returns. What an annual profit and loss statement misses are the events of each month, or quarter, that could identify challenges or successes well ahead of crisis moments. Again, unlike the cash statement, which is a snapshot picture of the business, the profit and loss statement is a moving picture of the business over a period.
Balance sheets
The usefulness of the cash position statement and the budget are most helpful when updated regularly. Still, the most useful financial measurement comes from the balance sheet. While it is also a snapshot of the business at any given point, a balance sheet becomes an immensely powerful tool to analyze the financial health of the farm or ranch business when compared to previous balance sheets. Essentially, when compared over time, balance sheets transform from short videos to longer movies of the operation. Properly completed, the balance sheet indicates how easy or difficult it may be to meet monthly bills and payments, and it indicates an accurate operating profit or loss as compared to previous balance sheets.
When compared over time, the balance sheet develops powerful trend indications. This is a paper scoreboard indication of how easily the business can generate cash to meet financing needs, repay loans and return a profit to owners. In summary, it is a record of what you own and what you owe against what you own, or, conversely, how much your creditors own of your things and what is left over. The part that remains is the measure over time that is most telling of the state of the business.
The part that is left over is referred to as net worth, which is also called "equity" or "earned equity." Over time, the earned equity is what a person or business has accumulated in life. Measured in intervals of quarters or years, earned equity shows the accumulation over and above debt, also known as a production profit.
The realities
So, let us look at what earned equity looks like in a real ag business. Assume “Hay Dude,” a hay farmer, owns $1,000,000 of farmland and $200,000 of equipment and supplies. He owes the bank $500,000 on a real estate mortgage at the start of a production cycle. His earned equity at that point is $700,000. Throughout the production cycle, he borrows $100,000 for operating expenses and produces 1,500 tons of hay. All the bills are paid, the hay is in the stack, and it's worth $250 per ton. It is mid-September. How much money (operating profit) did Hay Dude make in this production cycle?
The cash statement, or checkbook, will tell you he has no cash, as he owes the bank $100,000, plus interest, for an operating loan, and a real estate payment of $32,500. He is broke. The budget, or profit and loss statement, will tell you he lost $100,000 because that is what he spent to cultivate and harvest the hay in the stack. He lost money, he has no cash, and he is still broke. His cash basis income taxes will tell you he lost $100,000, plus whatever depreciation he has on his equipment. Is he still broke? Pay attention. A challenge is coming.
The above information is correct, but it is misleading to a modern ag businessperson. Understanding the three financial statements mentioned above will help any producer readily understand that these statements, by themselves, are misleading, and only tell part of the story. As ag producers, we need as much of the story as possible. Most of you know Hay Dude did not have a loss just from seat-of-the-pants figuring. However, let us challenge ourselves and find out exactly what Mr. Dude's financials look like in mid-September. Our analysis below works alike for Fortune 500 companies and small operations with less fortune.
Comparing Mr. Dude’s September balance sheet to his balance sheet at the start of the year will identify the complete picture, something we all need to know for our operations. Assume the following:
- Mr. Dude sells his hay for $250 per ton.
- He pays his operating loan to zero, plus $4,800 of operating interest.
- On the same day, he pays $20,000 in interest and $12,500 in principal on his real estate loan.
- Lastly, there is no change in the value of his real estate or equipment.
What is his operating profit or loss? And further, where on the balance sheet will that amount show up on that day in mid-September?
The correct answer will be explained in a future edition of this magazine. The first person to get the operating profit and loss number correct and to get the correct place and amount where the balance sheet reflects this figure, will receive a fabulous prize – email me the answers. That prize is an invitation to a steak dinner for up to four ag producers who are working to feed and clothe the world. The steak dinner will be at Indian Creek Steakhouse in Caldwell, Idaho. Excluded from this fabulous prize are the CPAs who keep all this straight. I will be happy to accompany the winner to this meal. I like my steak medium rare. What about you? Good luck, and watch for the answer in the May edition of this magazine.
