Financial statements provided by a farm operation act as a progress report on their financial condition. Financial statements in agriculture have become more standardized to incorporate industry ratios and measurements. This helps to understand the strengths and weaknesses of the operation and to benchmark against peers. Analyzing financial statements can also help provide strategic direction.
Typical financial statements that are reviewed by the bank consist of a balance sheet, an income statement, a statement of owner’s equity, and a statement of cash flow.
A balance sheet is simply a list of everything a person or business owns (assets) and what they owe against what they own (liabilities), which equates to equity or net worth as of a specific day in time. Bankers look for obvious changes from one balance sheet period to another (usually year over year) to assess any potential trends with their operators’ financial condition.
Two ratios are calculated using the balance sheet – Liquidity and Solvency (or leverage). Bankers look for the level of liquidity their operator demonstrates as it is a cushion of cash, in case the operator were to run into some short-term issues that using cash reserves may resolve.
One liquidity measurement is the current ratio (current assets divided by current liabilities) that measures the ability to meet living expenses, taxes and debt payments. Solvency, or leverage, is monitored by using ratios of debt against assets and debt against net worth. Less than 30% of the debt to asset ratio (debt divided by total assets) is considered comfortable whereas between 30%-60% is considered medium to heavy load of debt. Higher leveraged operators tend to be more risky to a bank because they have less ability to cover all of their debt if they were to liquidate their assets.
The balance sheet can also be used to review an operator’s debt schedule and may uncover opportunities to refinance existing debt. The opportunities may be beneficial to the operator in the form of more favorable terms and/or interest rates.
The income statement measures profit during a given length of time. Bankers monitor income and expense information to assess profitability and the probability the operator will be able to repay their loans.
Income statements can be on a cash basis or accrual basis. Trends in profitability increase or decrease are visible earlier with accrual basis as there can be a lag of 2-3 years with the cash basis. The accrual method is preferred by bankers because trends can be spotted earlier. This method recognizes revenue when earned and expenses when incurred, giving a more accurate measure of profitability.
Statement of Owner’s Equity
This financial statement analyzes why and how an operator’s net worth (or owner’s equity) has changed within a year. This highlights what forces caused the change by using balance sheets (beginning of year and end of year) and an accrual adjusted income statement. It is good to know what factors impacted net worth from year to year as well as how those factors might change over time.
Statement of Cash Flows
Projected cash flow is how cash is earned and spent (or enters and leaves) throughout the year. Projections are used to predict the future income and expenses, or cash flow, of an operator. The reliability of this type of information is entirely determined by the time and detail put into them by the preparer.
Bankers like to see the operator use historical data such as average yields, actual acres, and average expenses to give a decent picture of how the year may go given other existing factors such as loan interest rates, payment amounts, and projected crop prices. The cash flow can be a planning tool to help determine operating loans for the year/quarter.
Repayment capacity and efficiency ratios are calculated using the cash flow statement. Repayment capacity measures the ability to repay debts on time and often uses the term debt coverage ratio (what is left to spare after debt payments are made) and the capital replacement margin (what is left after operating expenses, taxes, family living and debts have been paid and is available for financing capital replacements such as machinery and equipment).
Efficiency ratios measure how effective farm assets are at generating income and where the gross income went, whether into operating expenses, depreciation expenses, interest expense or net profit.
The income and expense or cash flow trends of an operator do not necessarily predict the future ability of loan repayment. However, analyzing these trends is a good way for determining whether or not the bank should continue doing business with the operator as their spending habits have generally been developed by this stage.
All forms of financial information are useful to bankers in their own way. Various ratios are calculated using the financial forms as a tool to determine the financial health of an operator, monitor an operator’s financial progress, and assess the risk level of an operator. More importantly, the ratios allow the banker and the operator to compare the operator’s financial condition to peers of similar size and complexity for benchmarking.
The more often financial statements are reviewed, the earlier it is to be able to see trends and make adjustments. Financial statements are derived from the records of the operation, so keeping consistent records that are detailed and timely will provide the most accurate view of the operation.
Bankers work with operators using their financial statements to analyze performance for long-term sustainability. They can provide advice and resources for additional guidance on financial statement preparation and interpretation. Farm financial and accounting software or accounting professionals can help with statement preparation and ratio calculations.