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1206 PD: Business analysis: Which financial tools should I use?

Kevin C. Dhuyvetter and John F. Smith Published on 11 December 2006

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

An important point to keep in mind when analyzing a business is that the purpose of the analysis dictates the information required. For example, information needed for a tax analysis differs from a cash flow analysis, which differs from a profitability analysis. This implies producers will have “multiple sets of books” they need to keep so all of the different types of analyses can be done appropriately. The key point is that seldom is it appropriate to use a tax-based or a cash flow analysis as an indicator of profitability and vice versa.

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In addition to financial statements and tools, there are many production-related reports and measures absolutely essential when analyzing your business (e.g., production per cow, cull rate, pregnancy rate). While this information is extremely critical to successfully managing your operations, for the most part it will be ignored in this discussion, as financial statements and analysis methods are the focus of this [article]. The following is a list of the different financial statements and analysis tools that will be discussed individually:

•financial ratios
•partial budget
•net present value
•enterprise or whole-farm budget

While the above list is not all-inclusive of every possible financial statement and tool available for analyzing one’s business, it does include those most commonly used in the industry.

All of these financial tools can be used with actual data (ex post analysis) or with projected data (ex ante analysis), but the particular question at hand will often dictate which is the appropriate tool to use. For example, the balance sheet, income statement, cash flow statement and sources and uses of funds statement are typically used with actual data; whereas, partial budgets and enterprise budgets are generally constructed with projected data. Many times, cash flow statements are developed with both types of data – projected data for business planning and actual data for business evaluation. While this may sound like a trivial issue, the type of analysis you want to conduct will often dictate which tool is the most appropriate to use. Likewise, the data available may also influence which type of analysis is appropriate given the question at hand. The following is a brief description and discussion of each of the different financial statements or tools listed above with regards to their use in analyzing a business.

Financial ratios
The previous sections have discussed the key financial statements (balance sheet, income statement and cash flow statement) used to analyze the financial position and success of a business. Financial ratios are a means of using the information reported in one or more of the financial statements and interpreting it another way. By definition, the word “ratio” implies some value relative to some other value, so most financial ratios are independent of the size of the business, allowing different sized business to be compared to each other more easily.

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As with the financial statements, financial ratios are most valuable for both internal and external benchmarking of your business when multiple years of data exist. Internal benchmarking simply refers to examining how your business is doing over time when compared to itself. Thus, by definition, internal benchmarking requires multiple time periods (years, quarters, etc.) of data.

External benchmarking refers to how your operation compares with other operations. Benchmarking ratios and measures fall into various categories:

•Liquidity and solvency consider the debt level and debt structure of the business.
•Profitability ratios measure the extent to which the business generates a profit from the use of its resources. •Financial efficiency ratios measure the intensity to which a business uses it assets to generate value of production and the effectiveness of production, purchasing, pricing, financing and marketing decisions. •Repayment capacity measures the ability of the business to cover its principal and interest payments and evaluate the potential to acquire and service additional debt.

When examining financial ratios and comparing them to reported guidelines or other dairies, it is important to recognize that farm type and other factors can influence some of these measures. For example, the guidelines for asset turnover will be different for a beef cow-calf operation than for a dairy operation. Likewise, a freestall dairy likely will have slightly different depreciation expense ratio values than a pasture dairy.

Financial statements for business analysis
The three primary financial statements (balance sheet, income statement and cash flow statement) are not only important, they are critical for analyzing the financial condition of a dairy and for making broad comparisons across dairies. A strength of these statements is that they rely upon information that has happened as opposed to what is expected (i.e., they are based on actual data rather than projected data). However, a weakness of these financial statements is that seldom can they be used to identify specifically why one operation is more or less profitable than another.

A temptation when benchmarking data from the financial statements is to focus on a particular measure without accounting for other factors in the operation. For example, laborsaving technologies often require larger investments and thus represent substituting one expense (depreciation and interest) for another (labor), and if the manager is focusing on one ratio (e.g., depreciation expense ratio), he or she may be missing the bigger picture.

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This does not mean benchmarking information should not be done, but it does point to the importance of making sure the comparison being made is appropriate. Put another way, it is very difficult to identify the profitability associated with a particular management style or strategy using financial statements by focusing on one particular measure (i.e., a univariate analysis), due to the many confounding effects. To accurately measure the profitability associated with a particular management strategy (e.g., facility type, milking frequency, heat abatement, bST use), using data from the income statement requires a large amount of data (i.e., information from many herds) and an analysis methodology that takes into account the variability across herds (i.e., a multivariate analysis).

Partial budget
A partial budget analysis is generally a fairly straightforward analysis, but depending on the question at hand, it can become more complex. Typically, a partial budget is used to examine the expected economic returns associated with a particular management intervention. The word “expected” is used because partial budgets are almost always based on projected data. Ideally, we would use the income statement with historical data to measure the actual observed returns associated with a particular management intervention.

However, often insufficient data exist with regards to both the number of observations (operations or years) and information about the characteristics of the different operations (e.g., facility type, static versus expanding herd size, milking frequency, etc.). In this case, a partial budget analysis based on sound assumptions about expected impacts is often the best indicator as to the expected returns of a particular management intervention.

This type of analysis simply examines the impact a change in the operation has on net returns in a three-step process. The first step is to identify the benefits of the intervention. Second is identification of the costs associated with the intervention. Finally, we need to compare the benefits (gains) made in the first step to the costs (losses) identified in the second step.

Figure 1* shows a schematic of what a partial budgeting analysis entails. To construct a partial budget, four values need to be identified:

(1) increased revenue
(2) decreased costs
(3) increased costs
(4) decreased revenue

It is important to note that not all four of these values will always be relevant and in some cases some of them cannot be quantified.

It can be seen that by identifying the four factors identified in Figure 1*, the profitability of a particular management intervention can be calculated. A positive economic return points us in the direction of a good decision, while a negative outcome tells us that moving forward with the decision will be detrimental to overall business performance.

In addition to calculating the profitability as benefits less costs (as depicted in the figure), a benefit-cost ratio can also be calculated (i.e., B / C). This ratio simply indicates the dollars of return generated for every dollar of cost. Once the partial budget has been constructed, it is often useful to do a break-even analysis or a sensitivity analysis around some of the projected values to determine the impact they have on profitability.

While profitable decisions ultimately contribute to improvements in balance sheets, income statements and cash flow statements, accurately assessing the profitability of individual decisions or the performance of individual enterprises can’t be done solely with these reports. Partial budgeting gives us the required process to accurately assess those changes in income and expenses that are specifically associated with a particular management decision, without the problem of having the profitability of that decision clouded by other activities on the dairy that are irrelevant to the question at hand. Thus, the partial budget is a very powerful tool for analyzing different interventions management might be considering.

Weaknesses of the partial budget are that it requires projections (not particularly a serious issue) and the fact that some income or cost impacts are overlooked (potentially a serious issue). Another weakness of the partial budget is it only shows the “marginal” impact on the business. Because there are times you will want to know what this does to the bottom line, it is only somewhat useful information for a manager. (The total breakeven for the dairy would likely be more meaningful.)

Net present value
Net present value (NPV) analysis is a means of taking into account the fact that a time value of money exists (i.e., a dollar tomorrow is worth less than a dollar today). Generally, a NPV analysis is nothing more than a partial budget (i.e., changes in income and costs) that takes into account the timing of the income and cost changes. There is no question that a properly done NPV calculation that also takes into account taxes is the best type of analysis to use; however, the increased complexity of this method is often not warranted.

Enterprise/whole-farm budget
An enterprise or whole-farm budget is similar to the partial budget, except (as its name implies) it is for the entire operation. This tool is very useful for looking at alternative scenarios with regards to facilities, milking frequency or any other management intervention. For a dairy operation that also has a cropping enterprise, it is suggested the crop income and costs be examined separately. Thus, we are referring to a dairy enterprise budget.

Similarly, dairy operations may want to construct separate dairy enterprise budgets for the milking herd and the replacement heifers. For dairy operations that do not have other enterprises, the enterprise and whole-farm budget are the same thing.

The advantage of the enterprise budget is that all factors have been accounted for, so it could be argued it is more difficult to overlook some impacts (a potential weakness of the partial budget). Thus, an enterprise budget subsumes a partial budget (i.e., anything you can look at in a partial budgeting framework can be duplicated in an enterprise budgeting framework; the difference being that many income and cost categories might not change across the scenarios being analyzed.

A weakness of the enterprise budget is that, like the partial budget, it relies upon projections. However, as previously stated, this is not a serious issue for those producers that have good historical data to use in making projections. Additionally, by conducting a sensitivity analysis, the enterprise budget can be very useful for examining and quantifying the potential risk associated with a particular scenario or management intervention.

Summary
There are numerous different financial tools and analysis methods that can be used when analyzing the profitability of a dairy business. However, as with many other aspects of the dairy, using the right tool for the job at hand is important. The key financial statements – balance sheets, income statements and cash flow statements – are very useful and critically important for identifying and measuring the success of your dairy. Likewise, these same statements can provide some useful benchmarking information.

It is important to remember, however, that when benchmarking individual measures, there may be confounding issues that need to be accounted for. If there are confounding effects, an analysis based upon one factor (i.e., a univariate analysis) can lead to misleading results.

Because of these confounding factors, using financial statements based on historical data to identify why a business is or is not successful can be difficult. That is, financial statements are very useful for identifying if a business is successful, but they are less useful at identifying specific management styles and strategies that led to that success. The exception to this is when financial statement information (specifically income statement information) can be analyzed from a large numbers of operations using a multivariate analysis methodology that accounts for the many varying characteristics of the dairies.

When insufficient information is available (either numbers of operations or information pertaining to the characteristics of the dairies), it is very difficult to identify cause-and-effect issues using financial statements. In this case, it is often more useful, and likely more accurate, to use either partial, enterprise or whole-farm budgets.

While partial and whole-farm budgets require projections of the various cost and return variables, it is easy to see what assumptions have been made and conduct sensitivity analyses around those where uncertainty exists. This is a preferred case to using actual data when information about confounding effects are unknown, meaning you can only guess at what might have been going on.

A key point to keep in mind as a dairy manager when analyzing your business is that basically all decisions you make are based on what you expect will happen in the future. Thus, the most important thing is having confidence in your expectations. Therefore, you need to ask yourself, “Do I have more faith in an analysis of financial statements using actual data or in a budget that is based on historical data and my best projections?” We believe that both types of analyses have their place, but it is important to use the right tool and method of analysis for the job at hand. 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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