5 minute read
Business of Farming
ANALYZING YOUR FARM BALANCE SHEET
MANAGING RISK - PLANNING FOR THE FUTURE
BY JARED DANIEL
Whether one farms full or part time, the business of agriculture is not free of stress and risks. To enjoy financial sustainability in the pursuit of agriculture, farmers need to have a solid grip on their finances and be able to manage the risks. One of the best ways to manage risk is to be familiar with one’s farm financial conditions and have a specific plan to improve it and deal with potential issues in the future. There are a handful of financial statements that can be constructed and analyzed to understand one’s farm financial position and think about how it can be improved. The balance sheet, or net worth statement, is the starting point of analyzing a farm business. The goal of this article is to help readers become more comfortable with evaluating the balance sheet. How does one analyze a balance sheet? The most comprehensive and revealing analysis of a farm’s financial position usually involves a trifecta of financial statements: the balance sheet, income statement and statement of cash flows. However, there are a couple of financial characteristics that the farm balance sheet can show us without the assistance of any other financial statements, including liquidity and
solvency. Liquidity is the ability of a farm to pay off its current debts with current assets. Solvency is the ability of the farm to pay off all liabilities if the farm sold all assets. The most common measures of liquidity are current ratio and working capital. The current ratio formula is:
Current ratio =
current assets current liabilities
A ratio of 1.0 means that there are exactly enough assets to cover liabilities. This sounds okay, but it also means that the farm has no safety net to cover unexpected expenses in addition to short-term liabilities. Generally, the larger the current ratio, the better, because a larger current ratio implies that there are plenty of short-term assets to cover short-term debts when they come due and still have some left over. A current ratio of 2.0 is generally considered to be good. As it is with most financial ratios, there are no set guidelines, and whether the current ratio is good or not really depends on the structure of the business and the level of risk one is comfortable with. Another measure of liquidity is working capital. The working capital formula is:
Working capital is a measurement of how much cash is left over after all current assets have been liquidated and all current liabilities paid off. Once again, there is no set number that is considered “good.” In general, a farm should strive to have enough working capital to purchase new inputs/capital if a good opportunity arose or pay off emergency expenses should they occur. The go-to measure of solvency is the debt-toasset ratio. This ratio tells you the percentage of your assets that are funded by debt. Aim for a debt/ asset ratio less than one, and the smaller the better, because it means that the farm business owns more than it owes and can therefore cover all debts if forced to sell the business today. The debt to asset ratio formula is:
Table 1 details general guidelines for what ratio values constitute “weak” and “strong” liquidity and solvency based on a variety of sources. However, it
Debt to Asset Ratio = total liabilities total assets
is important to stress that desirable values depend on the business structure. Values in between may be sufficient or need improvement depending on the enterprise in question.
Ratio Weak May be Adequate Strong
Current Ratio ≤ 1.25 1.25 - 2.0 ≥ 2.0
Debt to Asst Ratio ≥ .60 .3 - .6 ≤ .30
Table 1.
After taking measures of the farm’s liquidity and solvency, one can make plans to improve them in the future. Growing working capital and cash without increasing liabilities is generally a good start. In other words, increase or maintain cash flows while spending as little as possible for as long as possible. Of course, “making more with less” is not always achievable. However, by analyzing the balance sheet and understanding where the numbers currently are versus where you want them to be helps develop and stick to a plan to improve them. There are some final notes to consider. The financial structure of a business, especially a farm, can be difficult to change in the short term. Even if one can improve the farm’s balance sheet, it does not guarantee farm financial success. There are important measures of success that the balance sheet can’t shed much light on by itself, such as profitability and cash flows. However, the balance sheet is the foundation of financial analysis. Income and cash flow statements are based off information compiled for use in the balance sheet. If you can construct and understand the farm’s balance sheet, then the income and cash flow statements will be easier next steps to a complete analysis of a farm’s finances. The bottom line: if one isn’t constructing a balance sheet at least once annually, analyzing and comparing it to the past, this is the year to make it happen. An accountant familiar with farming can help create a balance sheet or find a software to help with the task. Keep detailed and organized financial records this season to ease the process of constructing a balance sheet at the end of the year. The easier the process is, the more likely one is to build and look over a balance sheet in time for the next season. Going through this process year to year will allow for comparison of balance sheets over time and to see how management decisions and plans are improving. Going through this process is the foundation to having a stronger hold on the farm’s finances, and therefore a stronger grip on being able to keep farming for many years to come.
