The last time I posted to the blog, I talked about money and how to manage your finances, particularly during a time of low market prices. As a refresher, remember that understanding your income and expenses is very important. This allows you to determine where you might be able to make changes so that you can spend less or make more money. I also mentioned the importance of proactively managing income and expenses as opportunities present themselves. If you are able to “lock” in a positive margin, or profit, for a date in the future, consider doing so, rather than waiting to see if the markets are better at that future date.
Now you may be thinking, I get it, I need to understand my cost of production. As long as my income is greater than my cost of production, I should be in good shape. That is true. It is just the beginning of becoming financially savvy.
The next step on your journey is to understand your financial statements. What are those? There are four key statements that all businesses rely on to understand the health of their business: 1. Balance sheet, 2. Income statement, 3. Statement of cash flows, and 4. Statement of retained earnings. For this article, I will focus on the balance sheet.
A balance sheet consists of assets, liabilities, and equity. (See Table 1) Assets are the things you own. That might be your checkbook balance, tractors, cattle, or land. Liabilities are the money you owe, so your operating loan, land contract, credit cards, or tractor loan. Your equity is what is left over after you subtract your liabilities from your assets. For example, if you had $400,000 in assets and $200,000 in liabilities, your equity would be $200,000. Another way to think about equity, if you sold everything today and paid all your debts, your equity is how much money you would have left over. It helps you understand how much you are using debt to pay for assets.
To go into further depth, I can classify my assets and debts by current, intermediate, or long-term. A current debt is one that I will pay for in the next year. Similarly, a current asset is one that I will convert to cash in the next year, for example, the money in my checkbook or a bin full of grain. Intermediate assets and debts have a longer lifespan. These are items that last 1-10 years. This would include assets like tractors or equipment and the debt incurred to pay for them. Finally, long-term debts and assets last over ten years. A home mortgage or land contract would be an example of a long-term debt and land and buildings are types of long-term assets.
By simply looking at your balance sheet, you can do some basic analysis. Determine your percent owner equity, which is your equity divided by assets multiplied by 100. In the sample farm, that would be $200,000 divided by $400,000 multiplied by 100, or 50%. That means you have debt on 50% of your assets.
Next, identify where you have most of your debt- is it short-term, intermediate, or long-term? What types of assets do you primarily have? In Table 1, most of the assets and debt are long-term, which is common. Long-term assets, land, buildings, and homes, are usually the most expensive because they are the most permanent. Because they are most expensive, they often have the most debt associated with them.
Look at your current assets and debts. Are your current assets greater than your current debts? This is your working capital. If it’s positive, that’s a sign of financial health. In the example balance sheet, we’d subtract $5,000, current liabilities, from $10,000, current assets to calculate a working capital of $5,000.
At least once per year, you should be updating your balance sheet. You can do this exercise alone or with your lender or Farm Business Management instructor. Make sure you include all of your assets and all debts (even things that are zero percent or that aren’t financed through a bank).
When you update your balance sheet, compare it to your previous balance sheet. Notice where there are changes. Are they positive changes, i.e. debt decreased, or negative changes, working capital has gone from positive to negative?
An understanding of your balance sheet is critical to the success of your farm. It may not always seem like much fun to spend time with financial statements, but they provide important insights into the health of your operation. Over time it will get easier for you to generate and interpret your balance sheet, which will help you proactively manage your finances. Start slow and ask a trusted financial expert if you have questions. Through practice, you will get it!