Farm business analysis - the process of retrieving, organizing, processing, and analyzing information used in farm business decision making - is a critical ingredient in the management of the modern farm. Managers must be able to quickly respond to changes in the prices of the inputs they buy and the products they sell if they are to maintain farm profitability in today's rapidly changing marketplace. Producers are no longer isolated from changes elsewhere in the economic system. They must successfully respond to changes in consumer tastes, government regulations, and a whole host of other changes that occur in the world beyond the farm gate.

Detailed and accurate information is a necessary component of the farm manager's decision making process. This is why good farm records are the foundation of good farm management.

The farm manager must be able to use business records in day-to-day decision making. Use of farm business records in management requires ability to organize information from the records, to select the relevant from that which is less important, and to focus on the areas of the business that need attention.

Types of Analysis

Farm business analysis may involve either the whole-farm or single enterprise. Whole-farm analysis considers business features that affect the entire business. It includes a balance sheet analysis which shows changes in total assets, liabilities and resulting net worth; income statement analysis which shows changes in business receipts expenses, and various accounting adjustments; business cash flow analysis which indicates the amount of funds entering and leaving the business; and ratio analysis which can reflect what is happening in the entire business.

Only a part of the business, typically a single enterprise, is considered in an enterprise analysis. A study may be made of the dairy enterprise on a farm that includes a dairy herd, crops, and a horticultural enterprise. A single crop enterprise, such as alfalfa, may be the item of interest even though it is produced on a farm that also produces hogs and corn. Usually, more attention is given to specific items of cost or production when completing an enterprise analysis. Comparisons with other similar enterprises are typically a part of this kind of analysis.

TYPES, METHODS, AND FRAMEWORK FOR ANALYSIS

Methods of Analysis

Several methods are available in completing a farm business analysis. These include comparative analysis, ration analysis, and projected analysis.

Comparative Analysis
Comparative analysis can be used for single farm comparison to compare performance of a particular farm business or an enterprise from a farm through time (for example, comparison of performance in Years 1, 2, 3). It can also be used for multi-farm comparison of one farm unit or enterprise with another farm unit or enterprise. Multi-farm comparison has limits because it is difficult to find comparable business units. For multi-farm comparison to be valid, it must be restricted to farm units that use similar technology and operate under similar conditions. For example, comparisons between Southeast Pennsylvania and North-Central Pennsylvania farms or farm enterprises can be very difficult to accurately interpret because of the different climatic and soil conditions that exist in those two areas.

Ratio Analysis
Ratio analysis is used largely in whole-farm analysis. This process involves computing ratios from farm business documents, such as the balance sheet, and comparing the computed ratio with established standards. These standards are not always well defined in terms of the specific values that indicate strength or weakness. Variations in farm businesses between regions and differences related to the type of enterprises also are a handicap. However, this method can be used as an early indicator of the condition of a business. That preliminary condition then must be confirmed with thorough study of the particular farm unit for which the analysis is being completed.

Projected Analysis
Projected analysis is used most frequently for cash flow and income statement analysis, but may also be used with other farm financial documents such as the balance sheet. The goal of the projected analysis depends on the document being projected. For example, the projected cash flow estimates cash receipts, expenses, and ash balance for a future period. A projected income statement (also known as a pro-forma income statement) indicates cash receipts and expenses as well as the projected accounting adjustments that convert cash measures into projected earnings for the period (net farm income). A projected balance sheet estimates changes in assets and liabilities and increases or decreases in operator's net worth over the period projected.

A projected analysis is dependent on development of enterprise and farm budgets. (A budget is an estimate of sources of income and amount of costs.) The budgets provide information for the projection of income, expense, net income, and amounts of resources used.

A Conceptual Framework for Analysis

The process encompassed in the term "farm business analysis" can be conceptualized in three questions. These are:

• Where are we?
• Where do we want to be?
• How do we get there?

These questions indicate that a business analysis begins with a review of current conditions - the resources available to the business, the current operating plan, the existing financial condition, and the skills and management ability of the operator.

Goals are a part of the process, perhaps best thought of as the end result of the analysis procedure. A comparison of goals and current position will indicate the changes needed to move the business from the current position to the position it will occupy at some future date.

Planning based on analysis of the business unit provides the answer to the final question. A business will progress toward a goal only if plans are developed that can move it from where it is to where the operator wants it to be.

The analysis process should begin with consideration of the business as a whole. What are the strengths and weaknesses of the unit? What is the financial condition as evidenced by the balance sheet and a review of net worth? How much debt is there? Is the debt manageable give the requirements for obligations such as taxes, family living expenditures, and business expansion? Does the income statement indicate that the business is profitable? Are resources (land, labor, capital) efficiently used by the business?

In considering the above questions, one should consider a number of factors. The land resource is expensive and scarce and should receive special attention in the analysis process. The degree to which land is used for appropriate high-profit crops (corn, alfalfa, soybeans) is an indicator of efficiency in land use. Other indicators are crop yield per acre and value of total farm production per acre.

Labor must be used efficiently if the farm business is to succeed. Various criteria are available for evaluating labor efficiency. Some of the better criteria are value of production per worker, quantity of product (pounds of milk sold per worker), and number of productive work units used on a specific farm.

Efficiency in use of capital is increasingly important because of the long-term upward trend in interest rates. Rate of return on investment and rate of capital turnover are the most often used measures of efficiency in use of capital. A rate of return on investment equal to current interest rates is a desirable goal, but rarely obtained on most operating farms. A practical goal for rate of return is one equal to or greater than the long-term average rate of return on farm assets. This long-term rate has averaged about six percent over the past several decades.

Rate of capital turnover is computed by dividing value of farm production by total capital investment. Rate of capital turnover realized on different farms depends on the major enterprises produced. Poultry operations have a very rapid rate of capital turnover (more than once per year in some cases) while beef cow-calf operations usually experience a low rate, requiring several years for a complete turnover of capital. Dairy operations have an intermediate rate, their capital turnover usually requiring about three years.

Sufficient volume of business is a key to farm business success and should be considered early in the analysis process. A farm must generate enough total dollars to meet needs for taxes, insurance, debt repayment, business expansion, and family living, after payment of cash operating expense. Typically, 70 percent to 80 percent of gross receipts are required for cash expenses. Thus, 20 to 30 percent of gross receipts are all that remain to cover fixed obligations and family living.

A quick estimate of required business gross receipts can be calculated by multiplying the some of fixed obligations and family living needs by four or five. For example, if the operating margin (cash receipts minus operating expenses) is 20 percent, the operator must sell $5 in farm product in order to have $1 for family living expenses.

Once an analysis of the whole business is completed, it is helpful to become more specific and consider individual enterprises. Yields, amount of inputs used, and costs of production become important criteria for analysis when considering a specific enterprise. In evaluating an alfalfa crop, for example, the farm manager should be concerned with tons of forage produced, feeding quality, the costs of producing the crop, sale price, and net income. With the dairy enterprise, pounds of milk produced, inputs used (feed, labor) and their cost, and income above cash costs are important analysis criteria.

The balance sheet and the income statement provide information about the condition of the business as a whole. Net worth and net farm income are factors that can be used to quickly evaluate the business. Certain ratios discussed in the next section can be calculated from the balance sheet and help to evaluate relative strength or weakness.

TOOLS OF FARM BUSINESS ANALYSIS

The tools of business analysis are composed of the financial records maintained for a farm business and the various documents that are developed from those records. Included in the list are budgets, the balance sheet, the income statement (profit and loss statement), and the cash flow summary.

Budgets

A budget is an estimate of the revenue, costs, and net income of a farm unit or an enterprise. Development of a budget helps the farm manager to organize information into a logical order. Income and expense items otherwise overlooked are often exposed through development of a budget.

The budgeting process is extremely helpful when visiting a lender, both because of the information available from budgets and due to the "businesslike" image created for the person who offers budgets to support a loan request. Lenders have more confidence in a prospective borrower who organizes and plans - both characteristics are reflected in a budget.

Budgeting is a basic farm business analysis procedure. Budget information is used in projections of cash flow, profit or loss, and the balance sheet. Cash flow projections based on budgets are more accurate and can offer more detail than those using last year's figures or strictly estimates. The projected income statement and balance sheet require budget information to accurately reflect the best estimates of business earnings and changes in owner equity.

The budget provides detailed listings of sources and amount of income and expenses. It indicates the amount of inputs required for the enterprise, such as quantities of grain, silage, hay, and other feed components. Costs are divided into variable (cash) costs and fixed (overhead) costs. Finally, the budget reflects returns above both variable and total costs.

Balance Sheets

Difference names are used to describe the document here called a "balance sheet." It is often called a financial statement and sometimes a net worth statement. The term "balance sheet" implies some kind of balance as part of the document. The balance relates to the relationship between assets on one side of the document and liabilities on the other side That balance results in the basic accounting equation which states that assets always equal liabilities plus owner equity.

Balance sheets may reflect both business and personal assets and liabilities or only business or only personal assets and liabilities. If both business and personal assets and liabilities are included, the result is a consolidated balance sheet. If only business assets and liabilities are included, the document is a business balance sheet. If the document includes only personal assets and liabilities, it is a personal balance sheet.

The balance sheet provides a "snapshot" of a business' financial position at a specific point in time. It is one of the most basic tools used in financial management and should be developed on an annual basis by every farm manager. By comparing end-of-year balance sheets from consecutive years, the manager can determine changes that are occurring in the various types of assets and liabilities. Changes in net worth, through time, can also be determined by comparison of balance sheets from several years.

Assets
A number of definitions are in order before proceeding with a discussion of using the balance sheet in farm business analysis. An asset is something having economic value that is controlled by an individual or firm. Assets include cash, personal property convertible to cash given sufficient time, and real estate. The length of time required to change the item to cash determines the type of asset. The types of assets are current, intermediate, and long-term.

Current assets are those which impact the business within one year. Current assets include cash, accounts or securities easily converted to cash, and commodities that will produce cash within twelve months. Inventory items (feed, fertilizer, fuel) and livestock raised for sale are current assets.

Intermediate-term assets are those items which are expected to impact the business after one year but within ten years. This category includes assets used in production of income. Machinery and equipment, breeding livestock, retirement accounts, and longer-term securities are classified as intermediate assets.

Long-term assets are primarily related to real estate. Land and improvements are the usual long-term assets.

Liabilities
Liabilities are the financial obligations incurred by an individual or firm. They are composed of current, intermediate, and long-term obligations.

Current liabilities are those which impact the business within one year. They include bills or accounts due with one year. Income tax, FICA or self-employment tax, real-estate tax, and notes are included in this category. Principal payments on longer-term debts and interest due within one year are also part of current liabilities.

Intermediate-term liabilities are those items which are expected to impact the business after one year but within ten years. They include debts due after one year but within ten years. Loans used to purchase machinery or equipment and breeding livestock are usually classified as intermediate.

Long-term liabilities are related to real estate and typically involve debts due after more than ten years from the initial date of the loan. Real estate mortgages are the typical obligation that appears on the balance sheet as a long-term liability.

Net Worth
Net worth is computed by subtracting total liabilities from total assets. Net worth reflects a position at a point in time and will differ day to day or year to year.

There is no standard form for the balance sheet. However, there is a degree of uniformity among these documents. Regardless of the source, a balance sheet will include current assets and liabilities, intermediate assets and liabilities, long-term assets and liabilities, and net worth.

Balance Sheet Analysis

The balance sheet provides a cross-section view of the financial side of a business. A review of the balance sheet provides insight into the financial health of the business. Comparison of balance sheets from a business through time provides a general indication of performance of the business.

The balance sheet analysis should begin with a comparison of total assets and liabilities. The difference is net worth. If total assets exceed total liabilities, the business is solvent and net worth is positive. When liabilities exceed assets, the business is insolvent and net worth is negative.

The net worth of a business on a given date indicates owner equity and is a very general indicator to a lender of the risk involved in making a loan. If net worth is large relative to total assets in the business, the loan can be well secured and the chance of loss is small. A smaller net worth may present an obstacle to securing credit because risk of loss to the lender is greater.

A comparison of current assets and current liabilities from the balance sheet indicates ability of the business to meet cash obligations as they come due. A business that is able to meet its current cash obligations as they come due possesses liquidity.

The balance sheet of a business in a healthy financial condition will reflect an excess of current assets over current liabilities. Typically, that excess should be one-and-one-half to twice as much in current assets as in current liabilities. The excess is needed for several reasons.

A first reason is to serve as a financial cushion in case of rapid change in price of property making up the current assets. A rapid drop in price will destroy the liquidity of a business that has barely enough current assets to cover current liabilities.

A second reason that excess current assets indicates good financial health is that this excess is the source of working capital for the business. Working capital is the source of funds for the current operating expense - items that must be purchased on a day-to-day schedule to keep the business operating. If there is a deficiency of working capital, the business must borrow additional funds or it must liquidate intermediate assets to secure working capital. The procurement of additional credit often takes time. If intermediate assets are liquidated, the assets that produce income for the business have been removed and future income flow will be reduced. Thus, asset liquidation is not a viable long-term alternative.

A number of ratios have been developed to help in review of the balance sheet. These should be considered as useful tools for initial evaluation of the document but not as the fail answer to the question 'what is the problem in the business?' They are general indicators pointing to a need for further study.

The debt structure ration (or current debt ratio) measures current liabilities relative to total liabilities. It is calculated as follows:

Debt structure ratio = Current liabilities/Total liabilities

The debt structure ratio indicates the part of total debt that must be repaid within one year. A ration of 1:4 (or .25) indicates that 25 percent of total debt must be repaid within one year. The higher the ratio, the greater will be the drain on cash reserves and the more risk of being unable to repay current debt obligations on time. A high ratio of current to total liabilities may indicate a need to refinance. The refinancing process typically converts part of the short-term debt to a longer-term obligation.

The debt structure ratio should be interpreted with care. It probably should be used only in association with other analysis variables to put it into perspective. For example, an individual with $500,000 net worth and $3000 of liabilities, composed of $2000 current liabilities and $1000 intermediate-term liabilities, has a debt structure of 2:3 (.667) but is in no immediate danger of financial distress.

The net capital ratio is a common measure of solvency. The net capital ratio is total assets divided by total liabilities. A business is solvent if the ratio is more than one - that is, there is more than one dollar of assets for each dollar of liabilities. However, a financially healthy business will have a net capital ratio of approximately 2.5 or more. This means that owner equity is 60 percent or more of the total assets used in the business.

The debt-equity ratio is a second measure of business solvency. The debt-equity ratio reflects the relationship between borrowed and equity (or owned) capital used in the business. It is computed by dividing total debt by owner equity. Lenders often refer to this ratio because they prefer to make loans to that borrower who has equity of 50 percent or more of total assets used in a business. Thus, lenders prefer a debt-equity ratio of less than one. This indicates that the owners contribution is more than that of the lender.

A financially health business will generally have a debt-equity ratio of .67 or less. However, this can vary depending on the quality of management, the enterprises that are the source of income, and the level of profits. Perhaps the most valuable feature of this measure of solvency is the trend value - that is, the changes that occur to the ratio through time. If the ratio deteriorates through time - that is, it increases in absolute size, there is reason for concern and a careful review of the farm business should be undertaken. A rising debt-equity ratio means that debt is increasing.

Figure 1 is a typical farm balance sheet. Current, intermediate, and long-term assets are itemized on the left half of the page and similar categories of liabilities are arranged on the right half of the page. Current assets and liabilities (and other categories) are arranged on opposite sides to facilitate comparison. For example, current assets on this balance sheet total $301,025 and current liabilities are $59,232.

Various balance sheet analysis criteria discussed above can be illustrated with Figure 1. For example, solvency can be determined by comparing total assets and total liabilities. Total assets of $1,207,771 exceed total liabilities of $466,592; so the business is solvent. The difference between assets and liabilities is net worth - a second criteria for analysis of the balance sheet. Net worth in this case is $741,179.

Net capital ratio computed from Figure 1 is 2.59 ($1,207,771/$466,592). This indicates good financial health for the business represented by Figure 1. The debt-equity ratio is .63 ($466,592/$741,179). This indicates there is 63 cents of debt for each dollar of equity - the operator owns somewhat more of the business than the lender. This also indicates a healthy financial condition.

Liquidity is measured by comparing current assets with current liabilities. Figure 1 indicates a large surplus of current assets over current liabilities - thus a high degree of liquidity for this business and an adequate supply of working capital. The current ratio provides much the same relationship in ratio form. The current ratio for this business is 5.08 ($301,025/$59,232), which is well above the level considered necessary for good financial health.

Income Statement

The income statement is the only tool of farm business analysis that measures profitability. Budgets, the balance sheet, and the cash flow projection are valuable and essential management tools, but they do not tell the manager if the business is profitable.

The income statement measures business earnings resulting from business operation as opposed to business ownership. While appreciation in value of business assets may increase owner net worth, that source of funds is available only if the business is liquidated. In contrast, the earnings reflected on the income statement are the result of operations. Those amounts may be used for current expenditures or as an addition to owner equity.

The income statement can be computed monthly, quarterly, semiannually, annually, or on some other schedule depending on what is needed for management purposes. Most farm businesses use an annual income statement. The annual statement is consistent with the production cycle for livestock and crop enterprises and with calendar year record-keeping and tax filing activities. This approach permits comparison of farm profitability from one calendar year with profits from prior and subsequent years. Three major sections in the income statement are receipts, expenses, and adjustments. The receipts and expenses section reflect cash flow during the year. The adjustments are necessary to convert cash flow to annual earnings by including inventory change, accounts playable and receivable, and depreciation. Consolidated income statements also include nonfarm income and family withdrawals in calculations.

Farm Operating Receipts
Farm operating receipts are the first group of items on the income statement. This group includes cash receipts from grain and forage crops, livestock and livestock products, government payments, and other sources of cash receipts from farming. The total of this group is gross farm operating receipts.

Farm Operating Expenses
Farm operating expenses are the second group of items found on the income statement. Operating expenses include outlays for seed, fertilizer, chemicals, machine hire, feed, veterinary expense, interest, and several other cash farm operating expense items. The total of these items is gross farm operating expense. Subtracting gross farm operating expense from gross farm operating receipts yields net cash farm operating income.

Adjustments
The adjustments included on the income statement account for those factors that affect farm earnings but are not reflected in a cash transaction. Included among the adjustments are value of farm products consumed by the farm family, changes in inventory, and changes in accounts payable and receivable.

The value of products consumed by the family represents production by the business. It is necessary to add this amount to farm receipts in order to accurately reflect total value of production by the business. Expenses related to producing home-consumed products are typically included in farm operating expense. Thus, the only adjustment required is to include value of the products in gross farm receipts.

Inventory change is a second and very important adjustment to be made on the income statement. Inventory change is determined by comparing beginning and ending inventories from the balance sheet, the goal being to determine the increase or decrease in inventory that occurred during the year. Items that may be the source of inventory change include feed and grain, seed, fertilizer, fuel, livestock, and other farm property. A larger end-of-year inventory means some farm production is reflected in inventory items rather than in farm receipts. That larger inventory must be included to arrive at an accurate measure of farm production for the year.

Accounts payable and receivable must be considered as the income statement is developed. If accounts payable have increased during the year, this represents expenses incurred (and properly charged against the year's production) but no paid. This can be resolved by adjusting farm expenses upward to account for the unpaid expense. If accounts receivable have increased during the year, products have been produced and marketed but payment had not yet been received. This represents production attributable to the year that should have been reflected in farm receipts. To adjust for that, it is necessary to increase receipts in the amount of increase in accounts receivable.

Net Farm Income
Net farm income, (farm profit or loss based on operating earnings), is net cash operating income (farm receipts minus farm expenses) plus the adjustment for value of products consumed by the family, plus inventory adjustment, plus adjustments for accounts payable and receivable, and minus depreciation. The consolidated income statement includes nonfarm income since employment off-the-farm had become an increasingly important income source in recent years. It may also include withdrawals for family living in arriving at a net figure. Choice of farm business, personal, or consolidated income statement is at the discretion of the individual farm operator.

Income Statement Analysis

Analysis of the income statement involves reviewing several variables available or easily calculated from that document.

Net farm income is the "bottom line" on the income statement and a good place to begin the analysis procedure. This figure represents return to unpaid operator and family labor, equity capital, and management. Over the long-term, net farm income is the amount available for discretionary use by the family and for business development. If a withdrawal for family living is made in computing net farm income, then net farm income represents the amount available for business expansion and risk-taking. When family withdrawals are not deducted in computing net farm income, the expenditures for family living have a priority claim on part of the amount reflected in net farm income.

Interpretation of net farm income requires good judgment on the part of the evaluator. More is generally better, but evaluation of the level of net farm income from a particular farm must be completed with a view to type and size of operation. A $7,500 net farm income from a 60-cow beef herd might reflect an excellent return. But that level of net farm income from a 60-cow dairy herd is unacceptable, based on recent rates of return for successful dairy operations. Thus, it is necessary to have standards for comparison in evaluating net farm income.

The standards needed in evaluating net farm income are available for some farm types and enterprises, but not available for others. In Pennsylvania, very good information is available about dairy farms; other farm types are more difficult to evaluate. Regional differences do exist and the evaluator should be careful that the standard being used is the appropriate one for the location of the farm under consideration.

The operating ratio is another variable that can be used to evaluate net farm income. The operating ratio is total operating expense (cash farm expense) divided by gross income. The ratio converted to a percentage reflects the part of gross income that is required to cover farm operating expense.

The difference between the quantity "100" and the operating ration as a percentage is the operating margin. For example, if the operating ratio as a percentage is 70, the operating margin is 30 (100-70). This margin represents the share of income that is available to cover family living, business fixed obligations, and business expansion. Generally, the operating ratio (or percentage) should be less than .75 (or 75 percent) which results in an operating margin of 25 percent or more.

Rate of return on total capital is a third analysis variable computed by making minor adjustments to net farm income from the income statement. Rate of return on capital is net farm income plus interest paid as a farm operating expense, minus an allowance for operator labor, with the total divided by average capital investment. (Remember that net farm income is the return to unpaid family and operator labor, equity capital, and management).

Example: A farm's income statement shows net farm income of $30,000, interest paid of $14,000, and an allowance for unpaid operator labor of $12,000. Total capital investment for the farm is $340,000. Rate of return to total capital is:

$30,000 + $14,000 - $12,000 = 9.41%
$340,000

The value computed for rate of return to total capital can be compared to rates of return for stocks, bonds, or other nonfarm securities. However, that is a valid comparison only if the farm operator is willing to liquidate the business and apply the funds in the nonfarm investment. Historically, capital invested in farming has not yielded as much return as capital invested in nonfarm securities. A more valid comparison for a continuing farm business is one made with other similar farms in the area or with the long-term rate of return to agricultural assets. The latter rate has averaged about 6 percent for a number of decades. (The reader should be aware that this low rate of return to farm investment has been compensated to some degree by appreciation in land value. Unfortunately, this gain can be realized only if the farm business is liquidated.)

Comparisons with other similar farm units must be approached with a cautious attitude. It is essential that the units selected for comparison are those with similar crop and livestock programs, using similar technology, and located in similar climatic and soil areas.

Figure 2 is a typical farm income statement. Cash farm receipts are itemized on the left side. An adjustment is made in the receipts section for accounts receivable. The sum of cash farm receipts and the adjustment for accounts receivable is gross farm income. Cash farm expenses are itemized on the right side of the form with an adjustment for accounts payable included.

Depreciation is added to cash farm expenses to arrive at total farm expenses. That amount is deducted from gross farm income to active at net farm income.

Figure 2. Farm Income Statement

Cash Flow

The cash flow plan is an essential financial management tool for Pennsylvania farmers. It addresses one of the most serious financial problems faced on farms today - the control of cash flow. The cash flow plan is the focal point of the annual farm planning process. If the cash flow plan is prepared carefully and in sufficient detail, it will provide a financial picture of the operator's enterprise selections, input needs, feed requirements, credit needs and repayment capacity, family living needs, and marketing plans.

To be most useful, the cash flow should be prepared on a projected basis; that is, it should represent a plan for the future. Actual cash flow (farm receipts and expenses) can then be compared with the projection to provide an early check on business progress and an opportunity to make timely adjustments if required.

Cash flow should be prepared on both an annual and monthly basis. The monthly cash flow is of critical importance in determining specific dates when loans are needed, when debt can be repaid, and when inputs will be purchased. The use of the cash flow in estimating amounts and time of financial transactions causes some people to view the document as a whole-farm budget.

The cash flow projection estimates the flow of revenue into the farm business and the flow of expenditures out of the business. Those flows are important because they indicate when cash surpluses or deficiencies will occur.

Cash flow says nothing about profitability of the business; profitability information is available only from the income statement. Cash flow includes no consideration of inventory change, accounts payable or receivable, or depreciation. The absence of these important adjustments means that profitability decisions based on cash flow will be grossly misleading.

A cash flow projection can be developed in either of two ways. Information from last year can be used to estimate current year revenue and expenses. Adjustment of last year's information will be necessary, depending on price change and change in the farming operation. This approach is quick but may not provide a high degree of accuracy.

A more exacting approach is to carefully plan the coming year's farm operation and base the cash flow on those plans. Several steps will be required in this process.

First, the scope of crop and livestock enterprises should be determined and detailed revenue and cost date about those enterprises should be gathered and organized; that is, enterprise budgets should be prepared. In addition to number of acres or number of head of each enterprise, decide on the technology to be used and the inputs, including machinery operations, that will be needed based on that technology. This crop and livestock information can be used to determine annual cash flow.

Step two is to estimate monthly enterprise income and expenses. To arrive at monthly cash flow, it is necessary to estimate when variable inputs will be needed and when machinery operations will be performed. Cost of the inputs and machinery operations must be determined. It is also necessary to determine when products will be sold and the amount of revenue that will be produced. The result of this process is an estimated monthly flow of income and expenses for all crop and livestock enterprises.

Transactions related to capital investment must be planned. This will include purchases, trades, or sales of capital items. Thus, it is necessary to decide when tractors will be traded, when the funds for a new barn will be needed and their amount, when the old bull will be sold, and when a new pickup will be purchased. These transactions are included in cash flow, depending on when the transaction occurs and the amount of funds received or expended.

Nonfarm earnings should be included in the projected consolidated cash flow. Wages and salaries earned off the farm, interest income received from investments, and other nonfarm source income should be included in the month they are expected to be received.

Family living expenditures and taxes are included in the month they will occur. Times of extra expense, such as holidays or vacations, should be planned and included in the consolidated cash flow.

Debt repayment should be planned and included for the month in which surplus funds will be available to make payment. Planning this feature of cash flow requires a review of receipts and expenses by month to determine when surplus funds are available.

The cash flow summary from the previous year is helpful in "fine-tuning" the projected cash flow. If the farming operation in the coming year will be similar to the operation during the previous year, comparisons may help in making adjustments. Those adjustments should be based on expected price or cost differences, production differences due to weather variations, or other differences between the year being projected and the one just completed.

The analysis of cash flow is largely a matter of continuous monitoring of receipts and expenditures and comparing what actually happens to projected cash flow. A primary advantage of cash flow analysis is that it provides an early-warning system for the business in terms of financial affairs. When major differences between projected and actual cash flow occur, the manager should complete a review of financial transactions and production practices to determine the reason for the difference.

Caution must be exercised in using cash flow to evaluate the health of a farm business. Cash flow can only indicate if current returns will pay current expenses, debt, family living, and other current obligations included in the cash flow document. An analysis of the health of a farm business should include a review of the balance sheet and the income statement, as well as the cash flow.

Figure 3 is an annual cash flow projection. It indicates the expected sources of cash receipts and estimated cash expenses for the year. Principal payments and family living are included and a year-end cash balance is computed.

Figure 3. Annual Cash Flow

After the tools described in previous sections have been applied to date from a specific farm business, and analysis information has been developed, it is necessary to interpret the results prior to making and implementing management decisions. That process of interpretation involves focusing attention on the information that is most relevant to the issues at hand. The manager's goal is to understand the environment in which the business operates, and to develop a strategy that will help it to grow and prosper in the future.

Signs of Pending Difficulties

There are certain finance warnings that provide early warnings for pending financial difficulties. A farm operator who has detailed records and who properly organizes the information from those records, will be able to note the early warning signs in time to make adjustments. Others learn of those signs much later, often when it is too late for easy solutions.

Accounts payable increasing or inability to pay bills on time, are one of the very early signs of approaching financial problems. The lack of sufficient funds for payment of bills for fertilizer, feed, and fuel may indicate more severe financial problems in the not-too-distant future.

A shortage of working capital is a second indicator of approaching financial trouble. Working capital is the difference between current assets and current liabilities on the farm balance sheet. An early sign of developing financial problems is a small, or decreasing, working capital position. The farm operator who has a negative working capital position can be almost sure of having difficulty obtaining short-term credit.

Failure of earnings (net farm income) to grow from one year to another is an "early-warning" signal of potential difficulty. The manager should review enough years to determine what has happened through time. Is this the first year for the problem or has it persisted for several years? The manager should also establish if the earnings result in a positive cash flow or if the deficiency is such that existing income will not pay operating costs, family living, debt payments, and fixed obligations such as taxes.

The initial issue on which the manager may want to focus attention is the earnings problem. That issue may involve very low net farm income or net farm income that is less than the manager considers suitable for the type of farm and size of investment. While analysis of the farm business should be a part of the ongoing process of farm management, earnings problems are negative cash flow, net worth not increasing from year-to-year, and failure to service debt on a timely basis.

The income statement is the focal document in considering problems with earnings. This is the only tool of financial analysis that provides information about profitability of the business. Thus, to study earnings, the manager should start with the income statement. Net farm income and the percentage returned to capital are two analysis variables that should be reviewed.

Analysis of the earnings problem can begin by determining the size of the problem and how long the problem has persisted. The size of the earnings problem often relates to the lifestyle and expectations of the individual family as well as the amount of equity they hold in business assets. Level of family living expenditures and family goals are important factors. A family that expects frequent recreational outings, long vacations, a luxury car, a new residence, and substantial amounts set aside for the children's college education require larger earnings than a family with more moderate aspirations. Also, the family with 80 percent equity in business assets does not require the higher level of earnings required by debt service if equity is only 40 percent.

Once the scope of the earnings problem is established, the manager should become more specific in his/her review. Is the problem caused by temporary or permanent influences? Temporary factors include low yields (caused by weather, insects, disease), price fluctuation, or inventory change. If low earnings are caused by one or more of these temporary conditions, the manager need go no further. He/she should determine the adjustments required by the temporary factors, make those adjustments, and proceed with longer-run operational decisions.

Permanent influences usually relate to basic management decisions. If the earnings problem relates to management, the manager should establish if it is an organizational problem or an operational problem. Organizational problems involve the way resources (land, labor, capital) are used. Operational problems relate to day-to-day decisions such as when particular tasks are done, how technology is used, and the amount of variable input to be applied to fixed resources.

When the nature of the earnings problem is established (organizational or operational), the manger must act to correct the problem. If low earnings relate to how the business is organized, it is necessary to change the farm plan to better utilize available resources. Enterprise budgets will help in this process. They indicate the resource requirements and potential earnings from each enterprise. The manager should proceed with a view to maximizing profitability given the constraints imposed by supply of resources and available technology.

Excellent planning tools are available for the manager's use in finding the best organizational plan for his/her farm. Linear programming is a computerized process that can be used to find the most profitable farm plan given the resources available. This procedure involves development of budgets for all possible enterprises, listing the kind and amount of available resources, and then solving mathematically (using the computer) for the unique use of resources that maximizes profit. Linear programming can be combined with computerized transitional planning to determine both the "best" farm organizational plan and the year-to-year changes that should be made in moving from the existing plan to a better one. (Linear programming is a computerized farm planning tool available through Penn State county extension offices. Transitional planning is available as part of the FinPack group of computerized farm planning tools and is also available through Penn State Cooperative Extension.)

If the earnings problem relates to operational factors, the manager must determine why the current operating system is not working and implement the necessary changes. This will entail an analysis of enterprise yields, receipts, costs, and value of farm production per worker. The manager also should review resource use for each enterprise, with emphasis on productive efficiency for crops and livestock and efficiency in use of land, labor, and capital. Crop enterprises should be studied with a view to how much of the available land is used for high-profit crops. Are crop production costs under control? Are machinery costs too high? Are crop yields comparable to neighboring well-managed farms and are crops marketed efficiently?

Livestock enterprises should be reviewed with particular attention to both economic and production efficiency. Is level of milk production per cow or number of pigs weaned per litter comparable to those of successful farms in the area? Are livestock product sales per worker at efficient levels: 500,000 pounds of milk per worker, for example, in the case of the dairy enterprise? Are fixed costs average or below when compared with surrounding similar farms?

Once the manager has established the cause of the business' performance problem, (organizational or operational), he/she must determine the courses of action that are open to help improve the financial health of the unit. Each farm unit is unique, but three broad courses of action are available. There are: (1) do a better job of what is now being done, (2) do more (or less) of what is now being done, or (3) liquidate the farm business and redirect the use of resources.

If the manager elects to try to do a better job with present resources, it means concentration on improving efficiency in the operation and management of the business. This includes production, marketing, and financial management. The goal is to increase earnings per unit by increasing yields, improving marketing to increase revenue, or reduce costs of production. Restructuring debt (refinancing short-term debt) may also be a required part of the adjustment process.

If the manager elects to do more or less with the current farm organizational plan, it means he/she has recognized a source of inefficiency and will act to correct that problem. For example, if there is excess capacity in machinery, equipment, or labor, land may be rented to better utilize the under-used resources. In contrast, some farmers may have spread their management and finances so thin that a reduction in size of unit could improve profits and cash flow.

The decision by a manager to "do something else" is a dramatic change and usually a stress-filled one. It usually means a complete reorganization of the business assets and liabilities. Depending on the individual situation, alternatives such as renting out land and other assets, off-farm employment, or selling part or all the assets may be considered.

Specific Solutions for Severe Financial Problems

Severe financial problems have no easy solutions. The solutions often require drastic steps. An assumption underlying these solutions is that the problems are related to financial difficulties rather than management of production. The following solutions are intended for farm units with more serious financial problems.

Increasing income without incurring added expenses will help solve financial problems. In days when farm debts were small and interest payments were low, it was often possible to obtain a part-time job to solve temporary financial difficulties. The magnitude of debt on some farms today makes this solution less feasible. It is, however, one alternative that should be examined, particularly at those farms where family labor can be substituted for operator labor and where the nonfarm job will help to reduce the debt burden.

Maintaining a good working capital position is a key goal of financial management. This can be accomplished by properly structuring debt. When purchasing capital assets, it is important to properly finance them, so as to maintain a correct balance between short-term and long-term debt. Once working capital has disappeared, it is often difficult or impossible to make changes.

Refinancing is a possible solution where a shortage of working capital and/or short-term debt repayment capacity are major problems, and equity exists in long-term assets such as land. However, this can become a dangerous habit and can be lethal unless the underlying production management or financial management problems are found and corrected. Some lenders view refinancing as the first step toward business liquidation.

Obtaining lower interest rates is easier said than done. However, in some cases it is possible to obtain Farm Service Agency financing at lower rates than offered by other lenders. This possibility varies from one year to another depending on FSA policy. Sometimes it is possible to renegotiate terms of land contracts, particularly if the land was purchased from a relative. If land contracts are altered, it will be necessary to seek help from a qualified tax accountant because the change in the land contract may result in income tax consequences.

Selling unproductive assets may help on some farm operations with assets that are currently not generating cash income. Examples of this may be wasteland, timberland, minerals, or a land area separated from the main farm by a road or other barrier. It could also be a set of buildings. Or, it may be sows unused or under-used machinery. There may be sentimental or other reasons for not disposing of the assets. At times, the appreciation potential of the assets may appear to be large. However, the sale of unproductive assets and using the proceeds to apply off debt is an excellent way to reduce debt without reducing income.

Selling productive assets and reducing size of the business is a difficult approach. This alternative is an attempt to salvage the business by selling off part of the income-producing assets and applying the proceeds to debt. One intent is reduction of the required interest and principal payments. However, selling some productive assets sometimes is not feasible without liquidating the entire business. The process of scaling back can create problems in matching machinery and the remaining land. Machinery may need to be down-sized or used to generate additional income through custom operation. Thus, the entire process requires careful planning. The crucial phase of this planning is to be sure that expenses are cut back more than income as a result of the partial liquidation of business assets.

Farm business analysis is the process of retrieving, organizing, processing, and comparing financial information from a farm business. The process is directed at providing the manager the information needed to make decisions regarding organization and operation of the farm business.

A farm business analysis may involve the whole farm or one enterprise. The analysis may be completed using comparative analysis, ratio analysis, or projected analysis. The latter is typically used with cash flow or the income statement as an estimate of future business performance.

Three questions can be used to outline the process of farm business analysis. There are: Where are we?, Where do we want to be?, and How do we get there?

The questions imply that farm business analysis involves reviewing current resources and the current operating plan, setting goals, considering alternatives, and deciding how to move the business from where it is to where the operator wants it to be.

The tools of farm business analysis include budgets, the balance sheet, the income statement, and cash flow. Budgets are used to organize information (receipts, expenses, resource use) about the enterprises that may be produced by the business. The balance sheet provides a listing of assets and liabilities of the business. The income statement converts cash flow into business earnings for the period under consideration, usually a calendar year. And cash flow indicates the flow of funds into and from the business. Analysis of information from these documents helps the manager to determine financial health of the business and to select changes in operations or organizational structure.

Several early warning signs may be detected from the farm business analysis. These include accounts payable increasing, a shortage of working capital, and failure of earnings to grow from year to year. These early warning signs usually point to an earnings problem, the issue on which the manager should focus attention.