How often have you heard about the importance of having financial statements? Perhaps you have heeded that advice and have used a variety of spreadsheet tools, software and outsourcing alternatives for creating accurate balance sheets and accrual income statements. Now what?
Your answer might be that they fulfill lender requirements and are useful for taxes. That is important, but you are leaving some significant players on the bench. It is time to get them in the game.
Putting accurate statements together just gets you the information needed to do real farm management. The next step is analyzing the information to discover the farm’s financial story, determine the balls and chains holding back profitability and make informed decisions tomorrow morning after breakfast to cut them loose.
There are multiple tools and methods for analyzing financial statements. It can be overwhelming if there is not a good way to process the information into actionable intelligence. While there is no one process, the following is a starting point that has worked well for me through experiences with dairy producers, lenders and my 18- to 22-year-olds in the college classroom.
- Implement a farm records system that provides accurate and timely beginning and ending balance sheets and accrual income statements.
- Use information from the financial statements to calculate key ratios and other key performance indicators (KPIs).
- Analyze key ratios and other KPIs in comparison to industry standards using the Farm Finance Scorecard or something similar, within business trend analysis and through peer comparison analysis.
- Profitability deep dive using the DuPont System for Financial Analysis.
It all starts with farm records. The old adage of “garbage in – garbage out” should be on a big poster in the farm office. Whether records are hand-written or use sophisticated software, they must be accurate, timely and consistent. Anything else can result in the wrong story being told and, worse yet, the wrong decisions being made.
Ratios are the workhorse of financial analysis. Ratios enable evaluation in context of something. For example, which is better: Farm A with $1.5 million of total revenue or Farm B with $900,000? An immediate answer might be Farm A. However, what if Farm A had $15 million in assets and Farm B had $2 million? Now which is better? A ratio enables comparison of total revenues generated per dollar of assets; that is, how hard each dollar of assets is working to create revenue. For every dollar of assets, Farm A is creating 10 cents of revenue, while for every dollar of assets, Farm B is creating 45 cents of revenue. Said another way, if Farm A could match Farm B’s ratio, then their $15 million in assets would be generating $6.75 million versus the current $1.5 million.
The ratio of total revenue to assets is called the asset turnover ratio and is a common metric. It is not the whole story, but it starts to put the financial story in context. Better yet, a deeper dive into the parts of the asset turnover ratio will provide actionable intelligence to improve profitability.
With ratios calculated, the next step is the three ways of analyzing ratios to discover the story those ratios are revealing. Every analyst, consultant, neighbor and lender have their favorite list of ratios and other KPIs to track and assess. You may already have your favorites, but if not, or as a source of comparison, the Farm Financial Scorecard developed by the Center for Farm Financial Management at the University of Minnesota and the University of Vermont Extension is an excellent resource.
The Farm Financial Scorecard is a long-used and recognized means to assess the five financial areas of liquidity, solvency, profitability, repayment capacity and financial efficiency. Ratios can be further categorized into areas of vulnerability, caution or strength. The ratios used are vetted and approved by the Farm Financial Standards Council.
The second analysis step is a within-farm trend analysis. Three-year trends are a minimum, but five years are better. As a mentor once told me, “It is not how close to the devil you are, it is which direction you are going.” Your asset turnover ratio may be in the cautionary (yellow) range when compared to the scorecard’s industry standards. However, if it was well into the red four years ago, then either good luck or your decision-making appears to be paying off. Why is it improving? Was it because of some change that was made? Can that change continue? Improvement is great, but what are next steps in continuing and enhancing that improvement?
The third analysis is comparison to peers. A good peer comparison can be challenging, as there may not be one that is a relatively close match to your operation. Care should be taken to know how peer financials were constructed to assure equivalency.
The value of a peer comparison is that it decouples your farm’s performance from the current times. For example, the years 2015 to 2018 were generally poor years for prices and profitability in the dairy industry. Thus, an analysis of your farm’s performance against the scorecard’s industry standards may have shown several vulnerabilities. Further, a trend comparison within the farm may have shown a worsening situation. Taken together, the conclusion may be that not only is the farm not keeping up with standards, but it is getting worse.
However, that conclusion may well have just been the poor macroeconomic conditions that existed during those years. The standards on the scorecard don’t adjust to current conditions, and if each successive year for a few years was a worsening macro situation, then that very well could be reflected in a worsening trends analysis.
A peer comparison during the same years may have given a different story. Yes, your farm may not have shown up well against industry standards and trends may appear to be worsening, but it may still have been at the top compared to peers. Of course, the reverse could be true as well. Thus, using all three analyses processes for evaluating ratios gives a much richer and complete story for making farm management decisions tomorrow.
There are short-term bandaids to fix liquidity and other financial challenges, but ultimately greater profitability is the permanent fix. Thus, the final step is a deep dive into profitability using the DuPont system for financial analysis to help determine where management time can be spent to improve profitability.
The DuPont system for financial analysis is a tool that breaks profitability down into three primary levers, each of which can be measured by a ratio. The three parts are:
- Working assets to create revenues to start with, measured by the asset turnover ratio
- Efficiency of input use and prices paid for inputs such that there are more profits left after expenses are paid, measured by the operating profit margin ratio
- Using someone else’s money to increase the farm’s profitable activities, known as leverage, and measured by total assets divided by total equity
Further explanation of how to use the DuPont model is beyond the scope of this article. However, the result is a diagnostic tool to indicate where the balls and chains holding back greater profitability might be and what decisions can potentially lead to a change in course.
Management gurus often recommend incorporating standard operating procedures (SOPs) to create both consistency of good practices and to provide time and information for deeper management and strategic thinking. That’s good advice and just as good for financial analysis SOPs as well. Don’t let lender requirements and taxes be the only value received from your financial statements; rather use them to discover your farm’s financial story and what actions can be taken tomorrow after breakfast to improve that story.
