Kendal Thompson, Business Consultant, Land O Lakes Feed Division

Why do you keep financial records?

Keeping financial records has historically been a challenge for many agriculture producers. Using and analyzing those records to make business decisions has been a task that has escaped even more producers. The value of both gathering and analyzing those records will continue to accelerate for most all of production agriculture in the future.

This question has recently been posed to producers in group settings on numerous occasions-"Why do you keep financial records?" Invariably, the responses have fallen into three categories and given in the following order:

 

1. Taxes

 

2. Credit

 

3. Management

Producers who have set out to turn that list upside down in importance have enjoyed a renewed commitment to managing their businesses. It is the goal of this presentation to help individual producers begin a commitment to that end.

Management responsibilities in nearly all businesses clearly fall into two categories:

 

1. Operations Management

 

2. Capital Management

Likewise, in most businesses that have a large number of employees, the responsibilities for the two areas of management are divided between different people. In many ways, that division of responsibility can be a sizeable advantage.

It is the function of Operations Management within an organization to use the assets owned by the business to generate the maximum amount of operating profit. Operations management will accomplish that by wisely selecting production inputs that will be best utilized in the business so that operating profits will be maximized. This category of management has little or no say in how operating profits will be spent.

Capital Management has as its function to wisely spend operating profits and set up a structure that will insure that those profits are used in an appropriate balance. It is also the function of capital management to be sure that new assets purchased will meet the performance standards established for return by the business.

Most farms have the same person "wearing both management hats" and making both types of management decisions. An operations mindset can inappropriately bias a capital management decision. Likewise, a capital management mindset can result in making operations management decisions that may not be sound.

It is perfectly all right to have the same manager "wear both hats". Effective farm managers have the ability to separate the process of making operations management decisions from the process of making capital management decisions. Both types of decisions should be made to meet their specific goals.

Before financial performance can be measured and compared, methods of accounting and reporting should be consistent with an agreed upon standard.

Two financial reports will be used to demonstrate financial performance in this presentation. Those reports are:

 

1. Income Statement

 

2. Statement of Financial Condition (Balance Sheet)

The income statement measures profit or loss for an operation throughout a specified period of time. Income statements are commonly prepared monthly, quarterly, and/or yearly. A very basic sample income statement is found below:

For the Period from 19XX to 19XX

A Statement of Financial Condition is also used in the process of measuring financial performance. This report is often times referred to as a Net Worth Statement or Balance Sheet. The Statement of Financial Condition reports values for one specified date in time rather than covering a specified period of time. This report has three components:

 

1. Assets

 

2. Liabilities

 

3. Owners Equity or Net Worth

A sample Statement of Financial Condition can be found below:

December 31, 19XX

Farm Financial Standards Council is an organization which has developed and published standards for reporting and analyzing farm businesses over the past ten plus years. Further information on the Council can be accessed through their home page at www.ffsc.org.

Operations management can be analyzed from the income statement. One of the key measurements to use is operating efficiency. The calculation for ATO can be found below along with the calculation for ATO from the sample farm income statement:

An operating efficiency of 40% and greater is desirable.

One of the responsibilities of Capital Management is to spend the operating profit appropriately. In any farm business, there are only 4 things which operating profit can be spent on. That list includes:

 

1. Interest

 

2. Family Living & Taxes

 

3. Debt Reduction

 

4. Growth

Operating profit funds should ideally be appropriated equally to all 4 areas.

The other function of Capital Management is to decide which assets should be purchased by the business. A business should purchase only assets that have the ability to meet the performance standards for return established by the business. Both the income statement and the statement of financial condition are required to make the calculations to analyze asset performance. The measurement for asset performance is called asset turn over or ATO. The calculation for ATO is found below along with the calculation for the sample farm:

ATO is expressed as a per cent. The 32% ATO calculated from this sample farm is an average ATO for production agriculture. An ATO of 60% would be desirable.

Analyzing the financial performance of a farm business is an ongoing process. An analysis should include averages and trends for Operating Efficiency and ATO over several accounting periods for a business. Each time a decision is being contemplated to purchase an asset, the potential ATO of that asset should be calculated.

Many farm managers have made their primary reason for keeping financial records as use for making management decisions rather than for tax or lending purposes. Those managers usually seek additional information on completing an analysis.

Ag. Financial Management Classes for producers are sponsored by Land O’Lakes throughout the trade territory. During the three-day interactive sessions, producers bring their own financial records to the class. Class participants work through the analysis process concepts and principles by first working on case studies and then completing the analysis for their own farm. Participants actually leave the class with an action plan completed for making improvements in their business. Contact your Land O’Lakes representative to enroll in an upcoming class.