The Seasons of Farm Financial Management Date: 3/1/2018 1:54:36 PM Author: Paul Dietmann Educational Opportunities: Articles Interests: Grain, Young, Beginning Farmers, Specialty Industries Share: Like so many other things on a farm, financial management is seasonal. There is a time of year when the farm manager should be updating the balance sheet. There is another time of year to calculate profitability measures. In this article we’ll sketch out a calendar of farm financial management chores. Fortunately, this calendar runs counter to the majority of a manager’s other duties on the farm. January and February are the height of the harvest season for farm finances. It’s the time to total all of the income and expenses from the previous year and get them ready to haul to the tax preparer. It’s also the time to take inventory of stored crops and feed, prepaid expenses, livestock, machinery and equipment, other assets, and update the farm’s balance sheet. The balance sheet can be completed after all of the end-of-the-year bank and investment statements have been received. After the balance sheet is done, we can use it to calculate liquidity and solvency. The most important liquidity measure is ‘net working capital’. We find this number by subtracting current liabilities from current assets. Approximately 10-15% of a farm’s current assets should be held in cash or near-cash assets; for example, stored grain intended to be sold rather than fed. The farm’s net working capital should be at least 15% of the farm’s gross annual income. If we come up short in either of those measures, we should strive to reach those targets over the next four years. Solvency is calculated by subtracting all farm liabilities from all farm assets, which yields the farm owner’s equity or net worth. The long-term goal is for the owner’s equity to be more than 50% of farm assets. A beginning farmer, or one who is undergoing a significant expansion may find themselves below that level. During January and February is when we should be doing some financial tillage in preparation for the year ahead. Create annual enterprise budgets for major crop and livestock enterprises. Incorporate those enterprise budgets into a month-by-month cash flow projection, which allows us to see when we might need to inject some cash to get the farm through the year. March is the time for profitability analysis. As soon as the farm’s Schedule F has been finalized, we can combine it with the year’s beginning and ending balance sheets to calculate Rate of Return on Assets (ROROA) and Rate of Return on Equity (ROROE). We need beginning and ending balance sheets to accurately calculate those measures because we have to factor in changes that occurred during the year in certain balance sheet categories such as feed inventories. We also need to factor in a fair value for the farmer’s labor. We want to see a ROROA that is greater than the interest rate being paid on farm loans. It doesn’t make sense to borrow money at 6% to plow it into a farm yielding a 2% ROROA. The ROROE should be higher than the ROROA. The farmer should be harvesting a better return on his or her equity than is being earned on all of the farm assets. March is also the season to measure and sift last year’s cash flow. Was there enough cash to cover operating expenses, family living, income taxes, and all scheduled debt payments? If the farm’s net working capital fell short of the 15% threshold, was there enough cash left to build up some reserves? After covering all of these demands on the farm’s cash, was there anything left to replace assets that rust and rot? We want to make sure there was enough cash flow to cover all of the demands on the farm’s cash including a contribution toward working capital reserves and capital asset replacement. We’d like to see that there was 15% more cash available than was required to meet all of the demands. If there wasn’t, it’s important to dig a bit deeper and try to find ways to increase available cash or reduce the demands on it. After March, the rest of the year just requires some monthly maintenance. We’ll keep track of cash income and expenses, and make sure we are staying in the wheel tracks of the month-by-month cash flow projection we developed earlier in the year. We’ll want to make note of any purchases or sales of capital assets, and eventually capture the changes on the year-end balance sheet. We may need to update the balance sheet sooner if any new borrowing is planned during the year. If farm financial management tasks are scheduled on the calendar like other chores, such as machinery maintenance, we can keep the farm running at peak performance. Here are some helpful financial tools such as a month-by-month cash flow spreadsheet and a farm balance sheet. Season Chores January - February Total up the previous year’s income and expenses Make appointment with tax preparer Gather year-end bank statements Take inventory of stored crops, feed, livestock, prepaid supplies Update machinery list Complete year-end balance sheet Develop enterprise budgets Use enterprise budgets to build month-by-month cash flow projection for the year March Use the Schedule F and beginning and ending balance sheets to develop an income statement Use income statement to calculate Rate of Return on Assets and Rate of Return on Equity Use the Schedule F to create an annual statement of cash flows Calculate Replacement Margin Coverage Ratio April – December Monitor cash flow. Compare actual cash flow to projected cash flow each month Make note of purchases and sales of capital assets Paul Dietmann is a Senior Lending Officer at Compeer Financial. 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