Financial Analysis for Farm Succession 101€¦ · 21 Financial Measures 7 key ratios! Liquidity • Current Ratio* • Working Capital • Working Capital: Revenue* Solvency

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Extension and Outreach/Department of Economics

Financial Analysis for Farm Succession 101

Dr. Alejandro PlastinaAssistant Professor/Extension Economist

Department of Economics

http://www2.econ.iastate.edu/faculty/plastina/

International Farm Transition NetworkFarm Succession Professional Development Conference

Des Moines, IA - June 25, 2018


Overview

• How to identify red flags?

– Financial ratios

– Desirable vs. Available financial data

– Feasible analysis

• What to do about the red flags?

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Financial Analysis

• Profitability – is the farm making money?

• Liquidity – is it viable in the short term?

• Solvency – is it viable in the long term?

• Repayment capacity – lenders’ perspective?

• Financial Efficiency – how efficient is the farm in generating profits with its assets?


Source: Kay, Edwards, and Duffy (2017)

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What’s the financial status of this Iowa farm?

• Net farm income 2017: $115,000

• Working capital 12/31/2017: $147,000

• Net farm worth 12/31/2017: $2,000,000


21 Financial Measures 7 key ratios!Liquidity

• Current Ratio*

• Working Capital

• Working Capital: Revenue*

Solvency

• Debt: Asset*

• Equity/Asset

• Debt/Equity

Profitability

• Rate of Return on Assets*

• Rate of Return on Farm Equity

• Operating Profit Margin

• Net Farm Income

• EBITDA

Financial Efficiency

• Asset Turnover Ratio

• Operating Expense Ratio*

• Depreciation Expense Ratio

• Interest Expense Ratio

• Net Farm Income from Operations Ratio*

Repayment Capacity

• Capital Debt Replacement Capacity

• Capital Debt Repayment Margin

• Replacement Margin

• Term Debt & Lease Coverage Ratio*

• Capital Replacement and Term Debt Repayment Margin

Financial Guidelines for Agriculture, www.ffsc.org

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Liquidity

• Measures the capacity of the farm to operate in the short term

• Ratios:– Current Ratio

– Working Capital: Gross Revenue

• See Table 1


Current Ratio

Measures ability of operation to pay off all current liabilities if current assets were liquidated.

Calculation:

=CurrentAssets/CurrentLiabilities

Benchmark:Vulnerable 1.1 1.7 Strong

2016 2015 2014

Current Ratio 2.49 2.68 3.11

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Working Capital: Gross Revenue

Measures operating capital available in the short term against size of businessCalculation:

Benchmark:Vulnerable 10% 25% Strong

2016 2015 2014

WC:GR 45% 48% 53%


Solvency

• Measures financial leverage in business

• Ability to pay off all debts if operation were liquidated

• Uses balance sheet only

• Ratios– Debt / Asset

– Equity / Asset

– Debt / Equity (leverage ratio)

• Debt/Asset + Equity/Asset = 100%

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Debt/Asset

Measures financial risk and borrowing capacity.

Measures bank’s share of the business.

Calculation:


2016 2015 2014

D/A 26% 24% 22%


Profitability

• Profit is needed to meet financial obligations, service debt, fund family living, and build equity and growth

• Uses Net Farm Income from Operations, and includes accrual adjustments, depreciation, and interest.

• Measured over the year (instead of at a point in time)

• See Tables 2 and 3

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Rate of Return on AssetsRate earned on all investments in the farm (irrespectively of how they are financed)Calculation:

Benchmark Vulnerable 4% 8% Strong

2016 2015 2014

NFI+Int-Unpaid labor&mgt $43,662 $24,702 $92,638

Avg. Farm Assets $2,483,736 $2,450,774 n/a

Rate of Return on Assets 1.76% 1.01% n/a


Financial Efficiency

• How effectively the farm uses assets to generate income.

• The four ratios sum to 100%– Operating Expense Ratio

– Depreciation Expense Ratio

– Interest Expense Ratio

– Net Farm Income from Operations Ratio

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Operating Expense RatioDisplays portion of farm income used to pay operating expenses

Calculation:

. .


2016 2015 2014

Total Exp. – Int – Deprec. $646,097 $706,031 $639,991 Gross Revenue $786,642 $827,522 $823,329 Operating Expense Ratio 82% 85% 78%


Net Farm Income RatioMeasures profit against farm incomeMeasures amount left over after all expenses to pay for unpaid family labor and management, and own capital (retained earnings).

Calculation:

Benchmark: Vulnerable 10% 20% Strong

2016 2015 2014

NFI Ratio 5.9% 4.1% 12.2%

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Repayment Capacity• Measures the borrower's ability to repay term

debts (both farm and non-farm) on time. It includes non-farm income and so is not a measure of business performance alone.

• The farm record data that are typically available do not contain enough information to calculate historical repayment capacity measures.


Term Debt & Capital Lease Coverage Ratio

Measures ability of operation to pay all intermediate and long-term debt payments

Benchmark Vulnerable 1.20 1.50 Strong

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&

2016 2015 2014

Numerator $83,045 $68,691 $129,338 Scheduled Ppal & Int Term Loans $25,496 $26,395 $23,402 Term Debt & C. Lease Coverage R. 3.26 2.60 5.53

Term Debt & Capital Lease Coverage Ratio


Key Ratios Review• Liquidity: strong, but deteriorating

• Solvency: strong, but deteriorating and reaching “under watch” area

• Profitability: vulnerable situation, very low rROA

• Financial efficiency: vulnerable situation, average operating expense ratio 82% and average NFI ratio 7%

• Repayment capacity: very strong, due to low term debt

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Financial Statement Trends

• One year generally does not tell the whole story!

• Financial analysis should be compared or benchmarked to– Similar businesses/farms

– Industry standards

– Past analysis for financial performance trends


More details

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What information did we use to run the financial analysis?

• Accrual net farm income• Non-current assets valued at cost value

(purchase price – depreciation)• Economic Depreciation (not tax depreciation)



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What information is typically available to analyze Farm

Succession cases?


Typically Available:• Most recent balance

sheet (market value)• Income tax reports

(3 years)• Some records of

production activities


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Challenges1. Only Cash records of revenues &

expenses

2. Only Market valuation of non-current assets in balance sheet

3. Consistency of Farm vs. Personal records

4. Do owners pay themselves a salary or collect leftover cash as payment?


Challenge 1. Problems with Cash Accounting (Schedule F Income)

• Taxes are cash based, so…

• …Schedule F prepared strategically to stay in low tax bracket (hold crops, prepay inputs, etc.)…

• …and use fast depreciation rules (Section 179 +bonus depreciation) when buying new machinery to minimize taxes paid.

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Problems with Cash Accounting

• Can mask financial issues for several years of low profitability when family living expenses paid with cash from: – Selling down inventory– Selling capital assets– Increasing accounts payable– Refinancing operating losses– Living off depreciation


The Schedule F is not an Income Statement

• Adjustments in inventory

• Depreciation

• Deferred sales

• Prepaid expenses

• Etc.

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Accrual Accounting• Its primary purpose is to report True

Profitability. • It attempts to match expenses associated with

producing revenue for a specific period. • Agriculture Accrual Accounting adjusts the

revenue received in the following manner:– First, revenue from prior year’s production

received this year, is subtracted.– Then, revenue earned this year but not yet

received, is added.


Accrual Accounting (cont’d)• Similarly, Agriculture Accrual Accounting

adjusts the expenses paid in the following manner:– First, expenses from prior year’s production paid

this year, are subtracted.– Then, expenses incurred this year but not yet

paid, are added.

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Accrual Income

• Includes all income actually produced during the accounting period, whether sold or not

• Includes all expenses incurred during the accounting period, whether paid or not


Average Net Farm Income in Iowa: CASH versus ACCRUAL (nominal)

$27,927$45,597

$94,990

$92,500

$0

$50,000

$100,000

$150,000

$200,000

$250,000

NFI Accrual NFI Cash

Source: Iowa Farm Costs and Returns. Ag Decision Maker File C1-10. Various years.

NFI Accrual = NFI CASH

– Economic Depreciation + Changes in Inventories

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Impact of Inventory Changes on Net Farm Income Calculation

• Two Farms

• Identical Schedule F

• Identical Net Cash Income in Schedule F

• Identical Economic Depreciation $40,000

Schedule F Jones farm Smith farmGross Income $500,000 $500,000Cash Expenses -450,00 -450,00Net Cash Income 50,000 50,000


Impact of Inventory Changes on NFIBut Jones farm had a great year and the inventory increased by $100,000; and Smith had a bad year with hailed out crops, dry summer and low yields so they had to sell old crop, resulting in inventory decrease of $100,000 Jones farm Smith farm

Gross Income $500,000 $500,000

Cash Expenses -450,00 -450,00

Net Cash Income 50,000 50,000

Inventory Change +100,000 -100,000

Econ. Depreciation -40,000 -40,000

Net Farm Income 110,000 -90,000

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Impact of Economic Depreciation on Calculation of Net Farm Income

$59,313

$131,202

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000NFI Accrual

NFI Accrual + Econ Depreciation

Source: Iowa Farm Costs and Returns. Ag Decision Maker File C1-10. Various years.


Impact of using Depreciation from Schedule F on NFI Calculation

• Mr. Jones purchased a no-till drill 3 years ago, and is using an accelerated depreciation schedule for tax purposes:

• Economic depreciation based on straight-line method: $50,000

Schedule F Jones farmGross Income $500,000Cash Expenses -450,00Net Cash Income 50,000Depreciation -80,000Schedule F income -30,000

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What can go wrong using tax depreciation?

Jones farm w/ tax depr.

Jones farm w/econ. depr/

Gross Income $500,000 $500,000

Cash Expenses -450,00 -450,00

Net Cash Income 50,000 50,000

Inventory Change +100,000 +100,000

Tax Depreciation -80,000

Econ Depreciation -50,000

Net Farm Income 70,000 100,000

NFI with Econ Dep +$30,000


Can we approximate NFI Accrual by averaging many years of Schedule F income?

No, we can’t!

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Is the difference between Cash NFI and Accrual NFI similar across farms?

FINBIN Data 2008-2010 Low income farms

High income farms

Cash net farm income -2,942 210,595

Accrual net farm income -51,336 432,276

Low income farms got worse; high income farms got better after accrual adjustments

No, it’s not!


Challenge 2. Cost vs. Market Valuation of Non-Current Assets

Asset Valuation:

• Market: current market value (less selling costs), influenced by higher/lower prices

• Cost: remaining value of investment (net book value=cost less accumulated depreciation), not influenced by changes in prices calculate retained earnings.

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Cost vs Market BasisAsset Cost Basis Market

Basis

Marketable securities Cost Market

Market Inventories Market* Market

Accounts Receivable Cost Cost

Prepaid Expenses & Supplies

Cost Cost

Growing Crops Cost Cost

Purchased Brd Lvstk Cost Market

Raised Breeding Lvstk Cost or base value Market

Machinery & Equip Cost Market

RE, Bldg, Improvements Cost Market

Source: Kay, Edwards, Duffy (2017)


Example: What is the Cost vs. Market Value of Land?

• Mom/Dad either inherited or purchased 468 acres of farmland over the years as follows:– 395 acres for $3,500/acre

– 24 acres for $6,000/acre

– 49 acres for $5,275/acre

• Average value today is $6,372/acre

• Cost = $1,784,975 Market = $2,982,096Rounded: [1,785,000] [2,982,000]

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What could go wrong?

• What if market value was assumed at $8,000 per acre instead of 6,372?

– $762,000 more value than “correct”

– $762,000 more equity (wealth) than reality

– Deferred tax liability up from $375,051 to $489,351

– Distorted financial ratios: Rate of Return on Assets, Debt to Asset ratio, and other ratios.


NFI (Accrual) and Net Worth per Acre in Iowa

Cost or Market Valuation?

IFBA uses Cost (or book) Value for long-lived assets. Why?

To keep better track of farm financial PERFORMANCE

(e.g. higher land values are not mistaken by increased

profitability).

What valuation method do lenders use? Why?

Market Value, to reflect value of loan collateral.

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Inventory(market cattle and hogs, grain, etc.)

• GAAP: Lower of cost or market value

• FFSC: Depends– Practicality of tracking and record-keeping

– Co-mingling

– Relevance/Materiality

– Consistent and Conservative


MARKET INVENTORIES Cost Market

Raised livestock/crops for sale Market1 Market

Purchased livestock for sale Either2 Market

Raised crops for production(feed)

Market3 Market

Purchased feedstuffs for production (feed)

Either2 Market

Purchased inputs for production (seed, fert, etc.)

Cost Cost

1 Market value less cost of disposal2 Recommendation is lower of cost or market value. If kept separate

from raised inventory then use cost. If co-mingled with raised inventory then practicality is market value.

3 Lower of cost or market preferred, market acceptable

Source: Kay, Edwards, Duffy (2017)

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What could go wrong?• 25,000 bushels of stored grain put into the

bin this year from this year’s harvest– Correct, consistent, conservative market value

is $3.30/bu or $82,500.• $82,500 of revenue on an accrual earnings

statement

– Instead the corn is valued at what the farmer hopes to get: $4.50/bu or $112,500

• $30,000 more income than what is “correct”

– Distorts OPM, ROA, and other ratios!


Challenge 3. Consistency of Financial Records

• Avoid arbitrary change in how assets are valued, where and how assets/liabilities are categorized, what is considered the entity, etc.

• Can’t compare if you are not consistent

• Define the Entity• Farm?

• Farm + Farm? Farm + Mom/Dad consolidated?

• Farm + Mom/Dad separately identified?

• Farm + Mom/Dad + Son?

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Consistency: apples to apples• 1,000 acres

– 340 acres owned ($5,000/ac)

– 660 acres cash rent• $650,000 gross revenue

• $124,000 NFI

• Interest = Depreciation = $0

• Total Assets = 3.1 mil

• ROA = 124/3,100 = 4%

• NFI Ratio = 124/650 = 19%

Close to strong efficiency

• 1,000 acres

– 0 acres owned

– 1,000 acres cash rent

• $650,000 gross revenue

• $56,000 NFI $68K less for addl cash rent

• Interest = Depreciation = $0

• Total Assets = 1.4 mil

• ROA = 56/1,400= 4%

• NFI Ratio = 54/650= 8%

Vulnerable efficiency

Apples to Oranges!


Challenge 4. Unpaid Family Labor and Management

• Somewhat unique to production agriculture.

• Example of two farms:– Farm A: Pays a $50,000 wage to themselves

during the year, and all family living comes from the wage earnings (no extra family living draw is taken).

– Farm B: The farm owner supplies labor and management, but is not paid a salary. No off-farm income. Leftover to be withdrawn as family living expenses $50,000.

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Unpaid Labor and Management• Both farms: Total Assets $600,000;

• (NFI + interests): farm A $30,000; farm B $80,000

rROA =(NFI + interests – Unpaid labor)/Total Assets

rROA farm A = ( $30,000 - $0 )/ $600,000 = 5%

rROA farm B =( $80,000 -$50,000 )/ $600,000 = 5%

• If we fail to include Unpaid Labor and Management in calculation of rROA for Farm B:

rROA farm B = $80,000 / $600,000 = 13.3%

Big distortion!


Feasible Analysis• Down and dirty (3 years of tax returns and

balance sheets)

• Adjust financial records as much as possible: Net farm income: from Cash to Accrual (

+Change in inventories – Economic Depreciation)

Balance Sheet: Conservatism, Practicality, Consistency. Adjust non-current assets to cost values to evaluate performance. Use market value for repayment capacity.

• Calculate key ratios, benchmark and ask lots of questions

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Limitations on Ratio Analysis

• Current Ratio Variables

• Debt/Asset Ratio reacts to Interest Rates

• Changes in D/A with Asset De-/Re-valuation when using market values

• Repayment Ratios Change with Prices

• Acceptable Profitability Ratios Today?


What to do about the red flags?

• Liquidity fixes

• Solvency fixes

• Repayment capacity fixes

• Profitability fixes

• Financial efficiency fixes

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Liquidity Fixes

• Fixes?– Restructure debt

– Negotiate Interest only payment

– Impose austerity measures

– Generate (more) off-farm income

– New or bridge borrowing


Liquidity Questions• How much inventory and when will it be converted to cash, risk

of conversion (price change)?

• How much receivables, how ready are they for conversion to cash, what quality are they?

• Type of enterprise (corn turns into cash once a year, milk is every month)?

• How liquid is the asset?

– feed, growing crops, age of market livestock

• Are all current obligations accounted for, verified?

– Credit cards, accounts payable

– When are they due? Today or in 8 months?

• When is liquidity being measured?

• Brokerage account (its value can change quickly)

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Solvency Fixes• Sell unproductive capital assets

• Get rid of unprofitable enterprises

• Strong marketing program and/or production contracting– Does not guarantee a higher price, but assures a

price/margin in advance

• Off-farm income

• Debt forgiveness

• Long run: Greater profitability


Repayment Capacity Fixes• Increase profitability (more on this topic next)

– Increase revenues

– Decrease expenses

• Increase off-farm income, reduce off-farm expenses

• Reduce family living expenses

• Restructure debt service– Interest only

– Longer amortization

– Debt forgiveness

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Profitability Fixes Increase Production• Mortality rates

• Conception rates

• Feed conversion

• Fertility and nutrition programs

• Health protocols and cow comfort

• Days in milk

• Timeliness of operations

Increase Price Received• marketing

• premiums and discounts

Reduce Operating Costs• More efficient production practices

– Feed waste

– Plant populations

– Pest control

– Animal health control

• Negotiate/Create lower input costs (seed, feed, etc.)

• Quality of inputs

• Negotiate more favorable rental arrangements

• Labor (training, incentives, communications, procedures)

• Outsourcing, partnerships, alliances


Financial Efficiency Fixes Reduce Operating Costs• More efficient production practices

– Feed waste

– Plant populations

– Pest control

– Animal health control

• Negotiate/Create lower input costs (seed, feed, etc.)

• Quality of inputs

• Negotiate more favorable rental arrangements

• Labor (training, incentives, communications, procedures)

• Outsourcing, partnerships, alliances

Reduce Interests

Reduce non-productive assets

Increase revenue

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ISUEO Resources

• If you still have questions after completing the feasible analysis…

• Consult with ISUEO Farm Management Specialists and Financial Associates


ISUEO Farm Management Field Specialists

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ISUEO Farm Financial Planning Program


Thank you for your attention!Questions? Comments?

[email protected]

http://www2.econ.iastate.edu/faculty/plastina/

Hope to see you at “Financial Analysis for Farm Succession – 102” in Room Iowa B,

tomorrow 8:00-10:00am, for hands-on experience.

Documents

Financial Analysis for Farm Succession 101€¦ · 21 Financial Measures 7 key ratios! Liquidity • Current Ratio* • Working Capital • Working Capital: Revenue* Solvency