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1106 PD: Business analysis: Which financial tools should I use?

Kevin C. Dhuyvetter and John F. Smith Published on 10 November 2006

Editor’s note: The following is the first of a two-part series discussing basic financial statements and analysis tools.

As a dairy business manager, when you need tax management advice you likely would not turn to your nutritionist for that information. Likewise, it is doubtful you would turn to your accountant or farm management consultant to help resolve reproduction problems the dairy may be facing. The point is that as a dairy manager one of your tasks is to make sure you identify the persons best suited to answer the question at hand. Similarly, when analyzing the financial status or condition of your business, it is important to have the right tool or method of analysis for the job at hand. When analyzing the financial condition of businesses, we typically think of using the three basic financial statements, which are:

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•balance sheet
•income statement
•cash flow statement

These statements are very useful for analyzing the well-being of operations from several different perspectives and, thus, are very important. However, these financial statements have limitations for some financial analyses, and they may not always be the appropriate financial tool to use. The objective of this [article] is to list some of the different financial tools commonly used and to discuss their relative strengths and weaknesses for analyzing your businesses.

The following is a list of the different financial statements and analysis tools that will be discussed individually:

•balance sheet
•income statement
•cash flow statement
•sources and uses of funds statement

Balance sheet
The balance sheet, also known as the net worth statement, represents a financial snapshot of a business at a particular point in time and is one of the principal financial reports of a business.

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Balance sheets can take on different appearances, but they all basically convey three critical pieces of information – assets, liabilities and equity. Assets reflect the overall magnitude of the business in terms of dollars of investment (i.e., what is owned in the business), liabilities reflect what is owed (i.e., assets that are owned by creditors) and equity or net worth reflects the owner’s share of the business. Defined in this manner, equity is simply calculated as the difference between assets and liabilities.

Assets and liabilities are often classified as being current or noncurrent. Current assets are those that can be quickly converted into cash in the normal business processes within a year (e.g., cash, milk, feed, calves). Noncurrent assets are those resources used to support production that are not typically expected to be sold in the normal business process (e.g., cows, equipment, buildings, land). Current liabilities are those debts that are due within a year (e.g., accounts payable, accrued interest, principal due on term loans). Noncurrent liabilities are the longer-term portion of notes payable (i.e., that portion not due within the next year). Examples of noncurrent liabilities are things such as land mortgages and building and equipment loans.

The value of assets in a balance sheet can be either market-based or cost-based. Market-based means the value of the asset reflects what it would be worth if it were sold at the time the balance sheet is constructed (i.e., its current market value). Cost-based means the value of the asset reflects its cost (i.e., what was paid for it when it was purchased) less any accumulated tax depreciation. Depending on the asset, these two valuation methods can result in similar or significantly different values for an asset. For example, the market- and cost-based values would basically be the same for purchased feed kept in inventory for short periods of time. On the other hand, these two approaches will often result in significantly different values for assets such as land and buildings that were purchased many years prior.

Because liabilities reflect dollars owed, valuing liabilities on the balance sheet is not an issue. When valuing assets on the balance sheet, the important thing to keep in mind is that it is done consistently over time. (It is often wise to value long-term assets using both valuation methods – cost basis for tax purposes and market value for lenders.)

Because a balance sheet represents the assets and liabilities of a business at a specific point in time (e.g., January 1, 2005), a single balance sheet has little value in terms of conveying the financial success of the dairy business. Rather, the balance sheet provides useful information to lenders and others as to the size of the business (i.e., assets) as well as how leveraged the business is (i.e., liabilities), which provides an indication of risk-bearing ability.

By having two balance sheets (i.e., beginning of the year and ending of the year), a measure of financial success can be measured with the balance sheet. However, balance sheets have much more value for measuring the success, or lack of success, of a business when past balance sheets can be compared to identify trends or changes in the business with regards to assets, liabilities and net worth.

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The balance sheet is an important financial statement that needs to be part of your business analysis. However, it is important to remember a single balance sheet only conveys information at a single point in time. Even when a beginning and ending balance sheet exist, allowing you to calculate change in net worth, the balance sheet does not convey enough information to know why net worth increased or decreased, so it can lead to wrong conclusions. For example, net worth may have increased in a particular year due to an infusion of outside capital (as opposed to the business being profitable). This potential problem of reaching inappropriate conclusions is significantly reduced the more years of balance sheets available for analysis. Thus, it is important to recognize the balance sheet as a financial analysis tool has limitations and is most valuable when multiple years’ balance sheet information exists so it can be used to identify important business trends.

Income statement
The income statement is the key financial statement for measuring the success of a business over a certain period of time in terms of net income or profit. The most common time period for farms is a calendar year, but larger businesses will often construct income statements on a quarterly or even monthly basis. The income statement is also often referred to as a profit and loss statement, operating statement or income and expense statement. As with the balance sheet, income statements can take on many different appearances with regards to how they are organized, but as a general rule they contain an income section and an expense section – with the difference between the two being net income (or loss).

Income statements can be constructed on a cash basis or an accrual basis. Understanding the difference between cash and accrual income statements is extremely important when analyzing your business. A cash income statement includes only the income received and expenses paid during the time period being analyzed; whereas, the accrual income statement includes the income earned and the expenses incurred in the time period, regardless of whether or not they were actually received or paid.

The key difference between cash and accrual income statements is that accrual income statements include inventory adjustments to reflect the income earned and expenses incurred for the time period. Because of these inventory adjustments, accrual income statements are typically harder to construct (and understand) compared to a cash income statement.

Most farm businesses report their income on a cash basis for tax purposes because of the great flexibility this provides them for income tax management. However, producers need to recognize the cash-based income statement may, or may not, paint an accurate picture as to the profitability of their businesses.

For example, it is possible for a profitable business that is growing to go a long time period (e.g., 10 years or more) and routinely show a loss for tax purposes. The opposite scenario is also true. For example, a business may have to pay income taxes in a year when it was unprofitable. The key point to remember is that cash-based income statements may, or may not, accurately depict the profitability of your business. Thus, it is important to construct an accrual income statement.

As stated previously, income statements often take on slightly different looks and formats, depending on who is constructing them. For example, the approach used at Kansas State University is to subtract livestock and feed purchases from gross revenue and calculate a value referred to as value of production. This value of production figure more accurately depicts the income produced on the farm as opposed to simply purchased. On the other hand, total cash expenses will look low using this approach because feed is not included in this category.

Other income statements will simply treat purchased feed as an expense and list it in that section. Using this approach, the total expense category will be more accurate, but the income category will be inflated potentially due to large feed inventories. The important thing to keep in mind is this difference is not relevant with regards to the bottom line (i.e., net farm income), but it does affect category totals, and it is important to be aware of how the income statement treats these different items when benchmarking.

The income statement is an important financial statement that needs to be part of your business analysis. The accrual income statement provides a good measure as to the financial success of your business over some time period (e.g., previous year). Furthermore, by looking at income and expense categories, the income statement can shed some light as to why your business was, or was not, successful. However, as with balance sheets, this is best accomplished when income statements from multiple years exist so trends and benchmarking can be done. (e.g., How did income this year compare to my five-year average? Which costs were higher than average? Which costs were lower than average?)

Cash flow statement
The cash flow statement is the third financial statement that should be part of any business financial reporting. The cash flow statement is a recording of the dollars coming in and going out of a business over some time period (e.g., year, quarter, month). It measures how well a business is doing at meeting its cash commitments. Cash inflows refer to money coming into the business (e.g., sales, loans) and cash outflows refer to money leaving the business (e.g., expenses, principal and interest payments and cash withdrawals). Cash flow statements can be either historical (actual data) or projected for a future time period. Projected cash flow statements are often developed for lenders as a means of showing how and when borrowed money will be repaid. This [article] focuses on the historical cash flow statement.

It very important for producers and those making business management decisions to recognize that cash flow statements are not the same as income statements (i.e., positive cash flow does not imply profitability or vice versa). While projected cash flow statements are useful for communicating with lenders and business planning, historical cash flow statements have little value in analyzing a business if accrual-based income statements and balance sheets are being constructed on a regular basis (i.e., monthly or quarterly).

Sources and uses of the funds statement
The sources and uses of a funds statement is similar to a historical cash flow statement in that it lists all the funds coming into a business (sources) and the funds leaving the business (uses).

Because the historical cash flow statement and sources and uses of funds both account for all dollars coming into and leaving the business, they are based on the exact same data. One difference between the two statements has to do with organization of how information is presented.

Another difference between the two statements is that the sources and uses of funds statement typically does not show as much detail as the cash flow statement. For example, expenses and receipts are aggregated rather than showing individual categories.

Like the historical cash flow statement, if all funds have been properly accounted for in the business, the sources (inflows) should exactly equal the uses (outflows). PD

References omitted due to space but are available upon request.

—From 2005 Western Dairy Management Conference Proceedings

Kevin C. Dhuyvetter, Agricultural Economist, and John F. Smith, Dairy Scientist; Kansas State University

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