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Monday, September 12, 2016

Use Your Income Statement to Understand Your Farm's Finances

by Betty Berning, Extension Educator

I’ve written a couple articles this year and all have been related to farm finances.  I am passionate about finance and economics, but I understand that finance isn’t the most glamorous topic for most people.  Would you believe that I’ve tried very hard to make these articles as exciting as possible?!  I know, I know, they’re not very exciting! 

Having said that, finances are very important.  They are critical to a farm’s success.  Without strong finances and a solid understanding of them, one’s operation will have a difficult time surviving.  Anyone can become better at understanding finances, it just takes time and practice (repetition).

I’ve written about understanding revenue and expenses and balance sheet.  If you recall, the balance sheet is one of four financial statements.  The other three are 1.  Income statement, 2.  Statement of cash flows, and 3.  Statement of retained earnings.  For this post, I’ll focus on what an income statement is and what it tells you.

An income statement measures profitability over time.  For example, your Schedule F from your tax return is an income statement of sorts.  Your Schedule F measures your income and expenses over the past year (a period of time) and calculates what is leftover (profit).  This is considered a cash-based income statement.  Table 1 below illustrates an accrual-based income statement.  You can see the types of items that are included as income and expenses and the net farm income for the year.  The table includes accrual adjustments which give you a better picture of how much money your farm actually earned.

Table 1  Accrual Based Income Statement

Crop sales
Crop inventory change
Livestock sales
Livestock inventory change
Government payments
Other cash farm income
Change in accounts receivable
Gain or loss on hedging accounts
Change in other assets
Gain or loss on breeding lvst
Gross farm income


Cash operating expenses
Change in prepaids and supplies
Change in growing crops
Change in accounts payable
Interest paid
Change in accrued interest
Total operating expense

Net farm income from operations
Gain or loss on capital sales
Net farm income
Source:  Center for Farm Financial Management, FinBin

By looking at your income statement, you can see where you are making and spending money.  Take some time to really analyze your statement.  Identify the areas where you spend the most money and the least money.  Ask yourself, where am I making the most money?  The least?  Are you surprised by your answers?  

I’d also suggest comparing your current income statement to a past income statement.  An easy way to do this is to compare your 2014 tax return to your 2015 tax return.  Or you could compare one month’s income statement to another.  For example, compare your June 2016 income statement to your May 2016 income statement.  Analyze what you see.  Notice where there are differences.  Did you spend more money on one particular expense?  Did you make more money in one time period than another?  Make sure you understand and can explain any variability you see in your income statements.

Remember the balance sheet that I wrote about last time?  Find that when you’re doing your analysis.  There are a few simple ratios you can calculate using your income statement and balance sheet.  These ratios will help you understand how efficiently your operation is running.

1.        Return on Assets (ROA):  This helps you understand how efficiently you are using your assets create profits.  Generally speaking, anything over 8% is very good.  Less than 4% indicates an opportunity to improve.  You can calculate ROA using this formula-

2.        Return on farm equity (ROE):  This ratio illustrates how much money you are making for each dollar of equity.  A ROE of over 10% is excellent; ROE of less than 3% suggests more work is needed.
The analysis described in the previous paragraphs might seem a little confusing and daunting.  I strongly encourage you to spend some time trying to do this analysis.  Dig into the numbers.  Sit with your banker or farm business management instructor.  Try to understand your numbers.

By doing this, you can begin to see where you might have opportunities to increase your revenue or decrease your expenses.  Additionally, you may be able to spot potential problem areas before they become problems and take steps to avoid them all together!  One of the keys to financial success is being proactive when opportunities and threats arise.  Finally, careful analysis of your income statement can help you budget for the future.  You can utilize your monthly or yearly income statement to estimate your revenues and expenses for the next month or year.  Again, this will allow you to be proactive in your finances.

I’ll go back to what I said at the beginning- finance isn’t the most glamorous topic, but it is critical to the success of a farm.  If you aren’t spending much time digging into your farm’s finances, start now.  Over time it will get easier and hopefully it will provide you with tools for even greater success.  

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