- - AGRICULTURAL CORE CURRICULUM - - (CLF1000) Advanced Core Cluster: AGRICULTURAL BUSINESS MANAGEMENT (CLF1350) Unit Title: Financial Planning and Analysis ____________________________________________________________________________ (CLF1351) Topic: FINANCIAL ANALYSIS Time Year(s) RECORDKEEPING 3 hours 3 / 4 ____________________________________________________________________________ Topic Objectives: Upon completion of this lesson the student will be able to: Learning Outcome #: (J-3) - Learn how financial statements aid the decisionmaking process in agribusiness management. (*-*) - List three measures of business performance and describe their use. (*-*) - List three standards for evaluating business performance. (*-*) - List and describe two measures of profitability. (*-*) - List and describe two measures of solvencey. (*-*) - List and describe two measures of liquidity. (*-*) - List and describe factors affecting profitability. Special Materials and Equipment: Personal computers and spreadsheet software References: Luening, R. A., Klemme, R. M., & Mortenson, W. P. (1991). THE FARM MANAGEMENT HANDBOOK (7th ed.). Danville, IL: Interstate Publishers. Resources: Deere & Company. (1987). FARM AND RANCH BUSINESS MANAGEMENT (2nd ed.). Available from: John Deere Technical Services, Department F, John Deere Rd., Moline, IL 61265. Evaluation: TOPIC PRESENTATION: FINANCIAL ANALYSIS RECORDKEEPING A. Financial analysis is a tool for evaluating both business plans (budgets) and business performance. 1. Planning and analysis are inseparable parts of the operation of a business. a. Planning charts the future of the business. Budgeting is the process of developing a finincial plan for a business. b. Comparison of actual outcomes with business plans can help improve both planning and performance. 2. Planning and analysis are part of a planning cycle which is continually repeated. The steps in the planning cycle include: a. A business plan is made. b. The plan is analyzed and adjusted. c. The plan is put into action (carried out). d. The results of the plan are evaluated. e. A new plan is made. B. Steps in the planning process: 1. Establish a set of business goals or standards for performance. 2. Establish the measures of performance. 3. Determine the strengths and weaknesses of the business in terms of performance. 4. Identify areas of potential improvement which are controllable and which will produce significant results within a reasonable period of time. 5. Evaluate the options available and make a plan. 6. Implement the plan. 7. Keep good records of business activities. 8. Evaluate the outcome using the established measures of performance. C. Business Goals and Standards of Performance 1. The goal of most businesses is to make money (profits). Other goals may be to increase the size of the business or its productivity. a. Productivity improvements involve getting a greater return (profit) for each unit of some input. For example, a manager may want to increase the amount of profit generated for each hour of labor used. Another goal might be to increase the return on every dollar invested in the business. b. Growth implies increasing the size of the business, for example, increasing the number of units sold. 2. Sandards are benchmarks for comparison. These can be: a. Planned performance b. Past levels of performance c. The level of performance of other businesses in the same industry 3. For example, a beef producer may wish to evaluate and set performance standards based on what has been achieved in the past. Perhaps in the last three years $1.15 was received for each $1.00 invested. The producer might then establish a target return of $1.18 and then set about determining how to increase productivity to meet this target. D. Measures of Performance 1. Bankers and business managers are interested in three measures of performance: a. Profitability b. Liquidity c. Solvency 2. Profitability is the most important objective of a firm. A business is profitable when it makes more than enough money to cover all of its expenses. 3. Liquidity is a measure of the firm's ability to pay its short-term debt. A business has good liquidity when it has enough cash to pay all of its short-term debts. 4. Solvency is a measure of the overall indebtedness of the firm. A business is solvent if total assets exceed total liabilities. 5. Measures of profitability, liquidity, and solvency are usually reported as ratios. Ratio analyis allows comparisons to be made with farms or enterprises of different types and sizes. a. Financial ratios for different industries are reported for various industries by companies like Dun & Bradstreet and Doane's Agricultural Management. Local producer groups also publish financial ratios and other statistics for comparison purposes. E. Profitability 1. Profitability is measured in terms of the amount of profit generated by different inputs to the business venture, known as the return to the input. a. The returns to different inputs can be compared from one year to another in order to determine whether the business is becoming more or less profitable. b. The returns to different inputs can be compared with other producers and with the industry as a whole. c. Projected returns can be compared with those actually realized by the firm. 2. Profitability can be measured by: a. Net farm income (returns to labor, management, and equity capital) b. Return to equity capital and management c. Return to total farm capital d. Return to equity or ownership capital e. Net profit margin 3. Net farm income is the net cash income adjusted for changes in inventories, accounts payable, and accounts receivable. a. Net farm income represents the return to the owner's equity, labor, and management. (This assumes the owner-operator does not draw a regular salary for labor or management.) b. The net farm income is calculated on the earnings statement (income statement). c. Changes in net farm income from year to year are a good gauge of business growth or decline. 4. Return to equity capital and management is the net income less an adjustment for owner labor. The value of labor can be determined either by the wage the operator could earn in another occupation, or the amount it would cost to pay someone else to do the work. Net Farm Income minus Operator Labor = Return to Equity Capital and Management 5. Return on total capital shows the percentage of return on investment in the business. It is the return to equity capital and management plus the return to borrowed capital divided by the average capital investment. a. The return on borrowed capital is the amount of interest paid. b. The average capital investment is the total assets at the beginning of the year plus the total assets at the end of the year divided by two: Beginning Total Assets plus Ending Total Assets Average -------------------------------------------------- = Capital 2 Investment c. The formula for return on total capital is given by: Return to Equity Capital and Management plus Interest Paid Return to -------------------------------------------------------- = Total Average Capital Investment Capital 6. The return to equity capital is the amount of money being made by the owner's investment in the business. a. It is calculated by: Return to Equity Capital and Management Return to ---------------------------------------------- = Equity Average Net Worth Capital b. Average net worth is the beginning net worth plus ending net worth divided by two. 7. Net profit margin reflects the returns to total capital per unit of production (i.e., dollar of product). a. Net profit margin is given by: Return to Total Capital ------------------------- = Net Profit Margin Total Value of Production b. Total value of production is gross receipts for the year. F. Factors Affecting Profitability 1. The profitability of an agribusiness is primarily a result of how efficiently it is operated. Efficiency is defined as the units of output produced per unit input. Efficiency is affected by: a. The size of the business (Larger businesses can take advantage of economies of scale and operate at lower cost per unit.) b. The productivity of crops and livestock c. The degree to which income is spent to pay interest on debt rather than to produce income. 2. The efficiency of the business can be measured using input-output ratios. Examples include feed efficieny in livestock production (pounds of meat per pound of feed) and the fuel efficiency (acres per gallon). 3. Expense-income ratios examine the financial efficiency of the business. Three types of expense-to-income ratios are: a. The operating ratio, which is defined as: Total Operating Expenses --------------------------- = Operating Ratio Gross Income This tells the operator how much of each dollar in gross income spent on operating the business. The lower the operating ratio, the more profitable the business is likely to be. b. The fixed ratio, which is: Fixed Expenses ------------------ = Fixed Ratio Gross Income This tells the operator how much of each dollar in gross income is spent to pay fixed costs. c. The gross ratio, which gives the amount of each dollar in gross income spent to cover total costs. It is simply the total of the fixed ratio and the operating ratio. 5. Investment ratios can be used to determine how efficiently capital is being used. The capital turnover ratio is a common measure. It shows how efficiently business assets are put to use. a. The capital turnover ratio is given by: Gross Income ---------------------------- = Capital Turnover Ratio Average Capital Investment b. In agricultural production enterprises, the capital turnover ratio should be above 20 percent. G. Liquidity 1. Short-term liquidity can be determined by calculating the ratio of current assets to current liabilities, which is known as the current ratio. a. The formula for the current ratio is: Current Assets ----------------------- = Current Ratio Current Liabilities b. The current ratio tells the manager how well the firm can meet its immediate obligations. Current assets should always exceed current liabilities for a given period. A desirable current ratio is in the 2 to 3 range. c. The information needed to calculate the current ratio is available from the balance sheet (net worth or financial statement). 2. Intermediate liquidity is determined using the intermediate ratio. a. The formula for the intermediate ratio is: Current + Intermediate Assets ----------------------------------- = Working Asset Ratio Current + Intermediate Liabilities b. This ratio should also be greater than one. c. Information for calculating the intermediate ratio is available from the balance sheet. d. Liquidity is influenced in part by profitability of the business. Current commitments are often met by transferring assets such as inventories (e.g., stored grain) into cash. In addition, the equity level and debt structure affect the firm's ability to meet current obligations. H. Solvency 1. A business is solvent if total assets exceed total liabilities. 2. The net capital ratio is a common measure of solvency. a. The net capital ratio is calculated as follows: Total Assets ----------------- = Net Capital Ratio Total Liabilities b. A one to one ratio means that the business would just be able to cover all its debts should it be forced to close down and sell out (liquidate). c. A ratio of less than one means that the business could not meet all of its obligations and might have to declare bankruptcy should it go out of business. 3. Another measure of solvency is the debt to equity ratio. a. The debt to equity ratio is given by: Total Liabilities ------------------- = Debt to Equity Ratio Net Worth b. Lenders are interested in the debt to equity ratio because it shows the ratio of borrowed to owned capital. For a farm or ranch, business lenders do not like to provide more than 60 percent of the total capital. Hence a debt to equity ratio of no more than 1.5 is desirable. c. A similar measure of solvency is the owner equity ratio defined as: Net Worth -------------- = Owner Equity Ratio Total Assets 4. Solvency is affected by the profitability of the various enterprises within the total business and economic conditions. A firm showing an increasing debt to equity ratio over time is in trouble and should look for ways of cutting costs and improving productivity. _________________________________________________________________ ACTIVITY: 1. Ask a farm mananagment consultant or agricultural banker to talk to the class about the importance of keeping good records and the use of financial anaysis techniques. 2. Have students analyze their record books to determine the profitablility, liquidity, and solvency of their projects. 3. The John Deere book, FARM AND RANCH BUSINESS MANAGEMENT, provides examples of financial analyses for a farm business on pages 3-5 to 3-17. A whole farm case study is presented in Chapter 13. The example balance sheets, earnings statements, and cash flow summaries make an excellent source of data for practice problems and use in creating computer spreadsheets as exemplified in CLF1100, Computer Applications, Agricultural Recordkeeping and Accounting (CLF1103) Supplemental Worksheet #4. _________________________________________________________________ 11/11/91 EEZ/JA/ch #%&C