1. Your Net Income Statement Gerry Schwab, Barbara Dartt, Sherrill Nott, & Roger Betz FIRM AoE Team

2. Net Income Statement Purpose Measures profitability through calculation of Net Farm Income (NFI) Summarizes, for a period of time, the income earned and expenses incurred

3. Net Income Statement Defined Includes revenues and expenses Does not include –principal payment –family draws –capital purchases Does include –depreciation –change in inventory –change in AR & AP Also known as Profit and Loss Statement

4. If the Question is: “Will there be any earnings left after expenses incurred?” The problem is Profitability Are $ income earned more than $ expenses incurred?

5. Profitability Defined Profitability measures the Net Revenue above Expenses that a business generates from the use of its resources including land, labor, capital and management. Profitability is the key for a business to improve its solvency and avoid cash flow (liquidity) problems.

6. Net Income Statement For: ___________________________ For time period: From _______ To _______ ***Income Statement*** Cash Farm IncomeQuantityValueCash Farm Expense Inventory Changes Crop & Feed MarketReceivables PrepaidPayablesTotal Livestock and other expenses && accrued Income items SuppliesExpenses Ending Inventory Beg. Beginning Inventory (-) -End (F) Inventory Change (=) (G)Net Operating profit (E+F) Depreciation and other Capital Adjustments BreedingMachineryBuildings &Other LivestockEquipmentImprovementsAssetsTotal Ending Inventory Capital Sales (+) Beginning Inventory (-) Capital purchases (-) (H) Depreciation/cap adj (=) (I) Net farm income(G+H)

7. Building an Income Statement NEED: –ALL Cash Income –ALL Cash Expenses –Plus Accurate Beginning and Ending Net Worth Statements to calculate changes in inventory

8. Issues in Building an Income Statement Identify clearly the person(s) or the business entity being described Specify time period being described Includes only income and expenses plus changes in inventory Don’t confuse income with assets Don’t confuse expenses with liabilities

9. Financial Statement Linkages Dec. 31, 19X1Dec. 31, 19X2Dec. 31, 19X3 HistoricProjected Balance Sheet 12/31/X1 Balance Sheet as of 12/31/X2 Statement of Owner Equity as of 12/31/X2 Pro Forma Balance Sheet as of 12/31/X3 (Flow Statement) Cash Flow Budget for 12 months ending 12/31/X3 Pro Forma Income Statement for 12 months ending 12/31/X3 Income Statement for 12 months ending 19X2 Statement of Cash Flows for 12 months ending 19X2 Source: Agricultural Financial Reporting & Analysis

10. Net Farm Income Unpaid family and operator labor Unpaid management Unpaid equity capital PURPOSE: Indicator of Farm Business Profit earned during the accounting period Net farm income is the RETURN TO: +$ Gross farm income +Ending inventory of -Beginning inventory of -Ending inventory of accounts payable +Beginning inventory of accounts payable -Cash operating expenses CALCULATION: Crops, feed market livestock, accounts receivable, and capital adjustments (depreciation)

11. Net Farm Income % (NFI%) PURPOSE: Indicates profit performance of farm business and may suggest required business size for desired lifestyle withdrawals. Determines how much return for each dollar of sales. Can be used to compare individual farms to industry average, standard, or past performance. CALCULATION : $ Net farm income  $ Gross farm income

12. Return on Farm Assets (ROA) PURPOSE: Provides an accrual measure of income that is determined before income taxes and interest expense as if the business has no debt. +$ Net farm income (NFI) +$ Interest paid -$ Charge for unpaid operator’s (family) labor and management CALCULATION:

13. Rate of Return on Farm Assets (or investment) (ROA or ROI) PURPOSE: To determine the before-tax rate earned by the $ of capital invested in the business. CALCULATION: $ Return on Farm Assets  $ Average Total Farm Assets

14. Rate of Return on Farm Assets Overall measure of profitability Non-farm income should not be included ROI Can vary with structure of business. (Owned land in business) Market vs. cost method to value farm assets will affect ratio Must consistently estimate the value of unpaid labor and management Comparison across farms is more meaningful using market values Comparison from year to year of an individual farm is more meaningful using cost values

15. Rate of Return on Equity Capital (ROE) CALCULATION: PURPOSE: To determine the Before-Tax Rate earned by the owner’s equity in the business. If assets were valued at market value, this rate of return can be compared to ratios that could be earned in the market from alternative investments. $ Net farm income - $ Opportunity Cost for: Unpaid labor and Management  $ Average Net Worth X 100 (to get on a percentage basis)

16. Rate of Return on Farm Equity Measures how well your equity capital is employed in the business Highly leveraged and under capitalized farms can get wild results Comparing across farms is more meaningful using market values Deferred taxes should be included for return using market value -- will show low return without including deferred tax

17. Value of Farm Production PURPOSE: To provide a measure of Gross Earnings Produced on farm + $ Gross Farm Income - $ Purchased Feed - $ Purchased Feeder Livestock  $ Changes in inventory of crops and feed, market livestock, accounts receivable, and breeding livestock CALCULATION:

18. Asset Turnover Ratio PURPOSE: To measure how efficiently farm assets are being used to generate dollars of value-added production. High asset turnover ratio provides increased opportunity for profit. CALCULATION: $ Value of Farm Production  $ Average Total Farm Assets

19. Operating Profit Margin PURPOSE: To determine the operation efficiency of the business. It indicates the percent profit earned per dollar of value produced. [($ Net Farm Income + $ Interest Expense - $ Opportunity Cost for unpaid labor and management)  $ Value of farm production] x 100 CALCULATION:

20. = Operating Profit Margin X Asset Turnover Rate % Return on Investment

21. If % ROA Is Not Satisfactory Must Increase 1. Operating Profit Margin and/or 2. Asset Turnover Rate

22. To Increase Operating Profit Margin Needs: Higher prices Lower overhead High yields Low operating expenses Change enterprise mix: –to higher value crops e.g. specialty or value-added Pay Attention To: Marketing of output and output mix Investment & finance Production efficiency Purchasing of input and input mix External analysis of new business alternatives

23. To Increase Asset Turnover Ratio Needs: Higher value of production Value of invested assets is too high Pay Attention To: Marketing of output and yield efficiency Investment in durable assets Alternative methods of asset control, e.g. renting, sharing, ownership, custom hire Liquidate non- productive assets

24. Term Debt and Capital Lease Coverage Ratio PURPOSE: Measures ability of the business to pay scheduled financial payments on term debts and capital leases. If calculated ratio is less than one (100%), potential liquidity problems exist. CALCULATION: +$ Net farm income +$ Non-farm income* +$ Interest on Term Debt +$ Interest on Capital Lease +$ Depreciation Expense -$ Income and Social Security Tax* -$ Owner withdrawals  $ Annual scheduled principal and interest payment on Term Debt and Capital Leases * In analyzing farm business only, you may prefer to exclude non- farm income. Also adjust downward the income tax obligations associated with the non-farm income.

25. Capital Replacement and Term Debt Repayment Capacity PURPOSE: To determine ability of the business to pay scheduled financial payment on term debts and capital leases. Indicates ability of business to generate funds for capital asset replacements. +$ Net farm income +$ Non-farm income* +$ Depreciation expense -$ Income and Social Security tax -$ Own withdrawals * In analyzing farm business only, may prefer to exclude non- farm income and also adjust downward the income tax obligations associated with the non-farm income. CALCULATION:

26. Capital Replacement and Term Debt Repayment Margin PURPOSE: To determine ability of the business to pay scheduled financial payment on term debts and capital leases. Indicates ability of business to generate funds for capital asset replacements. + Capital replacement and term debt repayment capacity -$ Payment on unpaid operating debt from a previous period -$ Principal payment on current portion of term debt -$ Principal payment on current portion of capital lease CALCULATION:

27. Operating Expense Ratio PURPOSE: Indicates percentage of gross farm income that was spent for farm operating expenses; used for comparing expense control of the individual farm with the industry average. ($ Total Farm Operating Expense - $ Farm Interest Expense)  $ Gross Farm Income CALCULATION:

28. Depreciation Expense Ratio PURPOSE: Can be used for comparing ownership expense on durable assets with industry average; provides indicator of amount of capitalization investment in depreciable assets. CALCULATION: $ Depreciation expense  $ Gross farm income

29. Interest Expense Ratio PURPOSE: Indicates percentage of gross farm income spent on interest expense. Can be used to compare individual farm to industry average, standard, or past performance. ($ Interest Expense ± Change in Accrued Interest Expense)  $ Gross farm income CALCULATION:

30. Framework for Financial Analysis

32. What’s Next? Review FINAN (FINPACK’s version of a net income statement and analysis)