Income Statement Are you making a profit?

Objectives Understand and utilize an income statement: Understand the purpose of an income statement Be familiar with income statement terminology and structure Be familiar with cost and accrual methods of determining Net Farm Income Understand the relationship with the balance sheet Be able to use the income statement for strategic purposes

Income Statement Use the income statement to determine the profit or loss during an accounting period. Tells you the financial position of the business over a period of time (generally your fiscal year). Return to Assets and Equity Return to Labor and Management Operating Profit Margin

Income Statement Fundamentals Profit = Revenue – Expenses Definitions: Revenue – Income earned during the accounting period Commodity Sales, Inventories, Accounts Receivable Expenses – Cash or noncash expenses during the accounting period Input Expenses, Depreciation, Accounts Payable, Accrued Interest & Expenses

Income Statement Grant County Farms Co. Year Ending December 31, 2013 Revenue:   Expenses: Cash crop sales Purchased feed and grain Cash livestock sales Purchased market livestock Inventory changes Other Operating Expenses: Crops Seed and fertilizer Market livestock Repairs, maintenance Government payments Fuel and lube Change in value of raised breeding stock Property taxes Gain/loss from sale of culled breeding stock Hired labor Change in accounts receivable Utilities Adjustments Total Revenue Accounts payable Accrued expenses Depreciation Total Operating Expenses Interest paid Change in interest payable Total interest expense Total Expenses Net Farm Income From Operations Gain/loss on sale of capital assets: Machinery Total Gain/Loss on capital assets Net Farm Income

Accrual-Adjusted Net Farm Income The Farm Financial Standards Committee recommends that anyone using cash accounting convert net farm income to accrual-adjusted net farm income. More accurate Better for management purposes

Income Statement Adjustments Gross Revenues Inventory -Beginning Inventory + Ending Inventory Accounts Receivable -Beginning Accounts Receivable + Ending Accounts Receivable Operating Expenses Accounts Payable -Beginning Accounts Payable + Ending Accounts Payable Accrued Expenses -Beginning Accrued Expenses + Ending Accrued Expenses Prepaid Expenses +Beginning Prepaid Expenses – Ending Prepaid Expenses Unused Supplies +Beginning Unused Supplies – Ending Unused Supplies Investment in Growing Crops +Beginning Investment in Growing Crops – Ending Investment in Growing Crops

Accounts receivable balance 1/1/13 was $4,110; balance 12/31/13 was $4,785 Property taxes for the year of $5,650 Accounts payable balance 1/1/13 was $6,131; balance 12/31/13 was $7,800 Utilities expenses were $2,195 Sold 530 tons of hay for $235 per ton Depreciation expense for the year was $59,600 Change in interest payable for 2011 is +$650 Cash interest paid during the year $14,175 Received $12,400 in farm program payments Sold a tractor for $24,000, the book value was $23,400

Income Statement Grant County Farms Co. Year Ending December 31, 2013 Revenue:   Cash crop sales $ 124,550.00 Inventory changes Crops $ (9,550.00) Government payments $ 12,400.00 Change in accounts receivable $ 675.00 Total Revenue $ 128,075.00 Expenses: Other Operating Expenses: Property taxes $ 5,650.00 Utilities $ 2,195.00 Adjustments: Accounts payable $ 1,669.00 Depreciation $ 59,600.00 Total Operating Expenses $ 69,114.00 Interest paid $ 14,175.00 Change in interest payable $ 650.00 Total interest expense $ 14,825.00 Total Expenses $ 83,939.00 Net Farm Income From Operations $ 44,136.00 Gain/loss on sale of capital assets: Machinery $ 600.00 Total Gain/Loss on capital assets $ 600.00 Net Farm Income $ 44,736.00

$44, 736.00 - $10,000.00 $24,736.00 Return to Assets: Adjusted Net Farm Income from Operations Less Opportunity Cost of Unpaid Labor Less Opportunity Cost of Management Equals Return to Assets ROA = $24,736.00 $2,776,936.00 =.009 ROA = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑡𝑜 𝐴𝑠𝑠𝑒𝑡𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 Red: Ratio less than 0.01 Yellow: Ratio between 0.01 and 0.05 Green: Ratio greater than 0.05 Goal: ROA greater than 0.05.

$44, 736.00 - $10,000.00 $24,736.00 Return to Equity: Adjusted Net Farm Income from Operations Less Opportunity Cost of Unpaid Labor Less Opportunity Cost of Management Equals Return to Equity ROE = $24,736.00 $2,155,536.00 =.011 ROE = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑤𝑛𝑒𝑟 𝐸𝑞𝑢𝑖𝑡𝑦 No rule of thumb. It is best to compare with similar operations. Want ROE > ROA. Goal: ROE greater than _____.

$44, 136.00 + $14,825.00 - $10,000.00 $39,961.00 Operating Profit Margin Ratio: Adjusted Net Farm Income from Operations Plus Interest Expense Less Opportunity Cost of Unpaid Labor Less Opportunity Cost of Management Equals Operating Profit OPMR = $39,561.00 $128,075.00 =.309 OPMR = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 Red: Ratio less than 0.10 Yellow: Ratio between 0.10 and 0.25 Green: Ratio greater than 0.25 Goal: OPMR greater than 0.25.

Repayment Capacity Capital Debt Repayment Capacity (CDRC) Are earnings available to cover principal and interest on term debt and capital leases? CDRC = Net Farm Income + Depreciation + Interest on Term Debt CDRC Margin The amount of capital debt repayment capacity above actual or anticipated term debt and capital leases. CDRC Margin = 𝐶𝐷𝑅𝐶 𝑃𝑟𝑖𝑛. & 𝐼𝑛𝑡. 𝑃𝑚𝑡𝑠 𝑜𝑛 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

Case Studies

Grant County Farms, LLC. Objectives Evaluate the company’s current financial health based on the income statement. Based on your evaluation, what suggestions would you give Grant County Farms, LLC to better manage their profitability? Based on you evaluation of Grant County Farms, LLC’s profitability, how do you feel about a growth strategy? What other information do you need to know?   Operation and Background: You are the owner of Grant County Farms, LLC. It is the end of your fiscal year, and you want to measure the health of your business through profitability analyses. Grant County Farms owns 700 acres of non-irrigated cropland on which it runs a winter wheat/fallow rotation. You also run 300 cow/calf pairs on another 700 acres. You have an excellent reputation as a farmer, and you come from a well-establish family in the area. You are the second generation to own this farm.

The relationship between your balance sheet and income statement Profit to Equity The relationship between your balance sheet and income statement

Profit from the Income Statement Paid in Capital from Owners Debt Capital Balance Sheet for ABC Farms Co. December 31, 20XX ASSETS   LIABILITIES Current Assets Current Liabilities Total Current Assets Total Current Liabilities Noncurrent Assets Noncurrent Liabilities Total Noncurrent Assets Total Noncurrent Liabilities TOTAL ASSETS TOTAL LIABILITIES OWNER EQUITY Total Equity Total Liabilities and OE + - - +

Managing Your Balance Sheet Profit comes into the business: Fund growth Replace fixed assets Leverage/deleverage Increase liquidity Distribute to owners Increase risk bearing ability through equity distribution

Liquidity Ratios Already learned Working Capital and Current Ratio. Working capital as a percentage of expenses: compares adequacy of working capital to operations How much of the year’s operation can you finance? Sales as a percentage of working capital: gauges working capital in relation to a year’s sales Working Capital as a Percentage of Op. Ex.= Working Capital ÷ Operating Expenses If W.C. = $180,000 and Op. Ex. = $353,548 $180,000 ÷ $353,548 = 0.51 Sales as a Percentage of Working = Sales ÷ Working Capital If W.C. = $180,000 and Sales = $450,000 $450,000 ÷ $180,000 = 2.5

Liquidity Working Capital near 50% of Operating Expenses Excess Adequate Marginal Minimum Current Ratio near 2:1 Current Ratio near 1.2:1 to 1.3:1 Current Ratio near of 1:1 Working Capital near 30% to 40% of Operating Expenses Working Capital near 50% of Operating Expenses Adapted from Northwest Farm Credit Services

Solvency Ratios Already learned Debt/Asset and Debt/Equity. Debt Coverage Ratio (DCR): amount of cash flow available to meet annual interest and principal payments Fixed Charge Coverage Ratio (FCCR): ability to meet fixed financing expenses First calculate adjusted EBITDA: Adj. EBITDA = Net Profit + Interest Expense + Taxes + Depreciation Expense – Taxes – Distribution/Draws Then calculate DCR and FCCR: DCR = Adjusted EBITDA ÷ (Interest Expense + Principal Payments Due) FCCR = Adjusted EBITDA ÷ (Interest Expense + Principal Payments Due + Unfunded Capital Expenditures)

Leverage DCR 1:1 DCR 1.2:1 FCCR 1:1 FCCR 1.2:1 Debt/Asset Ratio: Maximum Marginal Sustainable Strategic Debt/Asset Ratio: Dairy 50% Orchards 50% Irrigated Crops 45% Dry Crops 40% Livestock 40% Dairy 35% Orchards 35% Irrigated Crops 35% Dry Crops 25% Livestock 25% DCR 1.2:1 DCR 1:1 FCCR 1:1 FCCR 1.2:1 Adapted from Northwest Farm Credit Services

Guidelines for Using Ratios Compare, compare, compare… Industry Historical information Business lifecycle Consider the whole picture.

Case Studies

Jack & Jill Ranch Co. Objectives: Evaluate the company’s current financial health based on the financial statements. Understand the impact of growth on the company’s financial position. Based on your evaluation of Jack & Jill Ranch Co.’s financial position, how do you feel about their growth strategy? How do you feel that can prepare for growth? Operation and Background:  Jack & Jill Ranch Co. farm 400 acres of irrigated crop ground. They rent 100 acres and own 300 acres. 300 acres are planted to timothy hay, and the additional 100 acres are used to pasture their seedstock cattle operation. The owners of Jack & Jill Ranch Co. would like to expand their operation. They have the opportunity to purchase a neighboring 100 acres. Growth Opportunity: Jack & Jill Ranch have the opportunity to purchase an additional 100 acres of excellent hay ground. They would like to offer $4,000 per acre. If purchased, this ground would be used to expand their timothy hay enterprise.

Homework Complete an income statement for your farm. Calculate your ROA and ROE. Set targets for ROA, ROE, and OPMR.

One Minute Takeaway Take a minute to write down one or two ideas or takeaways from this lesson.

Sieverkropp Consulting LLC. Contact: Elizabeth Sieverkropp esieverkropp@gmail.com (509) 398-6858 Website: www.sieverkroppconsulting.com Training Program Homepage: www.sieverkroppconsulting.com/fsa-borrower-training-program-homepage