Step 1: Business Inventory
The farmers, lenders, and farm management instructors who cooperated in developing these educational materials agreed that like any planning process, farmers need to know where they are before they can decide how to proceed. This and the next several steps are an opportunity for farmers to consider their current business, their personal interests and skills, and the economic environment for their farm business and agriculture.
An inventory of a business often includes information about 1) the type and quantity of business assets and their productive capacity, 2) current practices, and 3) the business' financial strengths.
Objectives of Step 1
Needed to Complete Step 1
Results of Step 1
This Step Involves
This web page suggests questions farmers may consider and a procedure they may follow in developing an inventory of the current farm business. The inventory will include a summary of the farm's resources, a description of its enterprises, and an assessment of its financial status. Activities in completing this step will likely include:
- describing the current farm operation in terms of types and quantities of commodities generally produced, and total acreage (owned and leased),
- developing a list of non-land assets owned or leased by the business, and describing their productive capacity,
- outlining the quantity, type, and availability of human resources,
- summarizing the types and quantities of inputs used to produce each commodity (including owned assets), and describing production and marketing strategies/practices,
- analyzing each enterprise by assessing its production efficiency in terms of
- the dollar value of inputs and the dollar value of production,
- return to the owner's labor, management, risk, and equity, and
- comparing current production to past production and production by peer firms.
- listing the business owners, the farm assets each owns, and the method of compensating them for allowing the business to use their assets,
- assessing the overall farm business by
- comparing availability of inputs to what is needed, in terms of quantity and timing,
- developing up-to-date financial statements (cash flow statement, income statement, and balance sheet),
- comparing the current situation with past financial situations and the financial situation of peer firms, and
- measuring the farm's capacity to assume risk.
This Step Does Not Involve
Subsequent steps in the planning process offer opportunities to
- consider the owners' willingness to assume risk,
- specify assumptions and expectations about the industry and economy,
- assess the long-term feasibility of the current farm,
- identify resources in the community that may be incorporated into the farm business, and
- develop alternatives for the farm business and assess their feasibility.
This Step May Extend Over Several Years
The remainder of this web page suggests a series of activities for inventorying a farm business. Farmers should not expect to complete all of the activities the first time they attempt this step; there is too much information. Instead, farmers should expect to initially expand the documentation they already have, such as financial statements and a depreciation schedule. Then each year, they can enhance their description of the business. After several efforts, farmers will have a complete description of their farm. Adult farm management instructors indicate that it is not uncommon to take three years to develop a thorough description and understanding of a farm business.
Enterprise and Whole-farm Analysis
Inventorying a business can encompass two major analyses. One analysis focuses on each of the individual pieces or enterprises that comprise the business. The second analysis concentrates on the entire business; that is, the whole-farm . Most farmers are more familiar with a whole-farm analysis than with enterprise analysis. However, enterprise analysis allows farmers to recognize the level of profit being earned by each enterprise, and commit resources to enterprises that move them closer to their ultimate goal (as discussed in step 4 -- Setting Personal and Business Goals ). The analytical processes described in this manual focus on individual enterprises and the whole-farm.
Example. A cow-calf/small grain producer was certain that the livestock enterprise was profitable and that the crop activities were marginally profitable, if at all. However, the enterprise analysis revealed that the livestock activity was unprofitable while the crops were generating a positive return. Further analysis of the livestock enterprise revealed that the cost of replacement stock was too high relative to alternative strategies for maintaining the herd. Armed with this information, the farmer addressed/resolved this previously undetected problem.
Primary and secondary enterprises
Farmers often initially describe their operation according to the commodities they produce or the enterprises they operate. For example, a farmer may indicate the primary enterprises with a statement such as "I (we) operate a _______" and fill in the blank with a phrase like "small-grain farm," "wheat and cow-calf operation," "potato and durum farm," or "feedlot."
Farmers usually follow such a statement with a more complete list of commodities they produce or enterprises they operate. Identifying each commodity or enterprise, whether it is a primary or an ancillary activity for the farm operation, reduces the likelihood that secondary enterprises are overlooked when analyzing the current farm business and considering its future potential.
Land Resources and Productive Capacity
Land often is a second characteristic farmers mention in describing their operation. A complete inventory of land usage would indicate the acreage that is
- owned and operated,
- owned but leased to other farmers, and
- leased from other owners.
Land leased from others is included in the inventory because it is being used in the farm business. Land leased to others also is inventoried because the owner may have the alternative of operating it after the lease expires. Another common practice is to categorize land according to whether it is cropland, pasture, or has some other use.
A summary of the acreage used in the farm's primary enterprises also can be helpful; for example, 400 acres of wheat, 250 acres of corn, and 590 acres of pasture. But secondary products or uses should not be overlooked, such as straw for bedding, fall grazing, or fee hunting. The inventory also may indicate the typical yield for each of the products. Past production records are valuable in completing this activity.
It can be helpful to briefly describe the characteristics of each tract. The description probably begins with information about the number of acres in cropland or pasture, but since the emphasis during the planning process is on selecting a strategy for operating the farm in the future, the inventory also should report what can be produced on the land. This production potential is referred to as the land's productive capacity.
Relevant questions in assessing land's productive capacity may include what other commodities could be produced on the land, could the pasture/hayland be used to produce a crop, could the cropland be used for grazing, and could the land be improved (perhaps drained or irrigated). Brief responses to such questions provide a more complete description of the land. Likewise, this vision begins to lay the foundation for considering alternatives in later steps of the planning process. For example, farmers may want to identify possible by-products from the production processes and consider whether the by-products can be used on the farm or sold.
Another example of describing the productive capacity of an acre of land would be that it is able to annually produce 45 bushels of wheat, 60 bushels of barley, or 2 tons of hay, rather than only being described as having a market value of $600 per acre. Computerized mapping systems, based on soil type and other production considerations, are becoming "the norm" in assessing land productivity. Other considerations in describing land resources might include distance to trade centers, pest problems, legal restrictions on use, and the base acreage for participating in federal government farm programs.
Additional information for leased land would include the rental rate and possible duration of the lease. Information about the book value, market value, and encumbering liens further describes owned land. Some of the information for owned land may already be documented on the owners' balance sheet or other financial statements.
The attached worksheet suggests a format for organizing some of this information. However, farmers are strongly encouraged to customize the form or develop their own to best meet their needs. There is no right or wrong way to present the information.
Owners of farm businesses that do not rely on extensive acreage, such as a feed or seed processing plant, or a feedlot/confinement livestock operation that purchases needed feeds, may find it more useful to develop a description of that primary enterprise than to spend considerable time detailing their land uses. Capacities or alternative uses for the facilities may be part of the description.
Inventory of Equipment and Buildings
The next activity can be developing a list of all non-land assets used in the business. The depreciation schedule already lists equipment and purchased breeding livestock, and is a good document with which to start this process. The farmer would add to this schedule:
- equipment and purchased breeding livestock that have been fully depreciated,
- raised breeding livestock, and
- non-breeding livestock.
Farmers who maintain a detailed balance sheet may have much of this information already compiled, in which case, a copy can be inserted in the manual as part of this section.
Like land, the inventory of equipment could include an assessment of the asset's productive capacity. For example, a farmer does not own a tractor so it can be sold for $37,000. Instead, the farmer owns a tractor to use it in the farming operation; perhaps to complete 1,000 hours of work each year. If the farmer, during a later step of the planning process, selects enterprises that annually require 1,500 hours of work from that tractor, the farmer will have to make some changes.
Another example of productive capacity of equipment would be a tractor and drill that can be used to plant 150 acres of grain in one day. This is somewhat different than thinking about the machines as having an undepreciated cost of $32,000 or a resale value of $45,000. If the normal planting season is about 12 days, the farmer would be able to seed 1,800 acres (150 x 12). Plans to expand the operation to 2,400 acres of small grains would indicate that the present seeding capacity is likely to be inadequate.
Additional factors in describing equipment could include alternative uses for the equipment; other enterprises in which the equipment can be used; and the age, state of repair, acreage capacity, ease of transporting, useful life, and obsolescence of the equipment. Encumbering liens that may restrict disposition of the equipment also could be part of the inventory.
In assessing livestock buildings, relevant questions may address capacity and condition of facilities for housing, feeding, livestock handling, feed processing, feed storage, and waste management. The availability of water also is an important consideration. Factors considered for a grain enterprise could include capacity and condition of facilities for storage, processing, handling, and drying.
General farm buildings, such as the farm shop and machinery storage, could be gauged according to their capacity to meet current and future needs (especially as equipment sizes continue to increase). Such an assessment also will likely consider the buildings' age, state of repair, and potential for expansion or refurbishing. These factors secondarily influence value but primarily influence what and how much can be produced, or which tasks can be accomplished.
Like land leased from others, leased equipment and buildings should be inventoried since they are part of the farm's productive capacity.
A detailed description of livestock often is helpful. For breeding livestock, information about their age, projected productivity, death rate, cull rate, and replacement rate provides a more complete description of the herd than just the number of head and their current market value. For feeders, relevant information may include death rate, a summary of their general state of health, likely rate of weight gain, and feed efficiency.
By considering productive capacity farmers are thinking about what they can do with the assets rather than just measuring quantity and dollar value. Productive capacity focuses attention on productivity, and reinforces that the value of an asset reflects "what and how much" is expected to produce during the asset's remaining useful life. Different production practices and varying uses of resources are considered in step 6 when alternatives for the farm operation are identified.
Production and Supply Inventory
Farm businesses almost always have an inventory of goods. Last year's grain stored for sale would be part of the production inventory . The quantity, quality, and market value often are critical since this type of asset generally will be used only as a source of cash revenue.
Farm businesses also may have an inventory of supplies/inputs that will be used to produce another commodity on the farm. Hay raised for feed and fuel stored in the farm tanks fall within this category, even though one was produced on the farm while the other was purchased. The dollar value of these items may not be as critical as the fact that there is enough hay (measured in terms of quantity and quality) to feed the breeding herd for six months, and enough fuel to till and plant 400 acres in the spring. A description of supplies would likely specify quality, quantity, alternative uses, and restriction on uses (such as grain subject to a Commodity Credit Corporation loan). Again, some of this information may already be part of a detailed balance sheet.
In describing purchased inputs, farmers generally include inputs that are invested in growing crops, such as fieldwork completed last fall or chemicals and fertilizers already incorporated into the soil. In addition, the inventory could include inputs that have been purchased and paid for, but not delivered (commonly referred to as prepaid expenses).
Available Labor--the Human Resource
Labor is an important asset not listed on the balance sheet or depreciation schedule. A business inventory perhaps should include information such as
- how many people are working in the business,
- when and for how long they are available (such as full-time, summer months, weekends, evenings),
- their talents and skills (see step 2),
- their level of management or supervisory skills (see step 2),
- which skills should be improved (see step 2),
- their tasks,
- their rate of pay, and
- how the availability of this labor might change in the future (such as a teenage child leaving home in several years, a family member retiring, or an adult child leaving an off-farm job and being available full-time).
Developing an inventory of available labor poses some unique challenges for several reasons
- labor is not a homogenous commodity, each worker has different skills and talents;
- labor can be quantified using different measures;
- extra labor cannot be readily stored for use at a later time; and
- labor is necessary to utilize most any other resource in the business (such as equipment).
The following paragraphs provide a few suggestions for overcoming the challenges.
A farm inventory may have categories of available labor skills, such as equipment operator, livestock handler, craftsman/mechanic, or manager. The farmer may further sub-divide or categorize skills; for example, management could be subdivided into areas of production, marketing, financing, and interpersonal skills (which could include supervising and negotiating). Since all successful farms need to perform these tasks in varying degrees, the process of inventorying the farm's available labor may develop such categories.
Some managers may measure their available labor in terms of hours; for example, several workers will provide 150 hours of labor each week. Assessing labor on an hourly basis requires that labor needs (as addressed in a subsequent section) also be measured by the hour. An alternative measure of labor is workdays; that is, one person working an entire day provides one workday of labor and a task that takes one person one day to perform requires one workday of labor.
A description of when labor is available can be accomplished with further categorizing. A worker who is available in morning provides a different type of labor than someone who works in the afternoon; this may be critical to a livestock farm with chores that need to be completed at a particular time each day. Alternatively, labor provided by workers during weekdays could be categorized as different than labor provided on weekends. For example, an individual who is not available during weekdays may not be the person to assume responsibility for meeting with firms/agencies that are open only "40 hours" a week.
A broader category for the timing of labor would be the seasons. Crop producers may want to distinguish labor available in spring from that which is available during the summer or fall. Having a large supply of labor during the summer when most is needed in spring and fall does not assure the business will complete its tasks in a timely manner. The farmer has to decide the best method of describing when labor is available but categorizing labor according to time is one procedure to accomplish that. The issue of timing will resurface throughout the planning process.
Another challenge could be documenting the labor of an individual with several skills. For example, a multi-skill person could spend 11 hours in a day's time completing management tasks, or 11 hours operating equipment, or 11 hours handling livestock, or 11 hours doing any combination of these tasks; but the person could not spend more than 11 hours working that day. Subsequent steps of the planning process offer an opportunity to revisit this question; therefore, it may be adequate in this step to indicate that the individual's skills are available in any combination but the total is limited to the time the person has for work activities.
Resources Needed to Operate the Farm
The activities of this step, thus far, have focused on what resources are available. The next activities concentrate on the resources necessary to operate the present farm. After compiling these two sets of information (available resources and needed resources), farm owners are prepared to assess which resources are inadequate and which are under-utilized. In either case, some changes in the farm business may be necessary.
Developing a description of each enterprise is one procedure for compiling a record of what resources are used in operating the farm. A component of the description would be an enterprise budget that includes information about the quantity produced and the revenue generated. Some enterprises produce several sources of revenue. For example, a wheat enterprise could generate income in the forms of grain sale, government program payments, crop insurance benefits, straw, and fall grazing.
A detailed description of each enterprise also would include a list of inputs, the quantity used, cost per unit of input, and total cost for the input. For example, in producing wheat, a farmer may use 60 pounds of dry fertilizer per acre at a cost of $220 per ton for a fertilizer cost of $6.60 per acre. This information could be thought of as the "recipe" the farmer follows in producing the commodity.
Some farmers will conduct more than one enterprise analysis for some commodities. For example, multiple analyses are needed when the operator uses different technologies or levels of input to produce the commodities. A corn enterprise that follows a strategy of "minimum-tillage and high fertility" is distinct from one where corn is produced using "conventional-tillage" practices. Farmers will want to analyze the profitability and feasibility of each "recipe" to understand which one best utilizes their resources.
It is important that the enterprises be described as specifically as possible so the analysis accurately reflects the farmer's business. Otherwise in later steps, the farmer will be making decision based on faulty data for their business. It is for this reason that farmers cannot use general descriptions or budget values that are developed by others.
Crop enterprise budgets often are prepared on the basis of one acre whereas livestock enterprises often are on a per-head basis. An advantage to preparing enterprise budgets on a per-acre or per-head basis is the ease of changing the scale of the enterprise by multiplying by a different number of acres or animals. Such an approach, however, assumes that the productivity of each acre or of each animal varies little from the average. However, some farmers have or are developing records in sufficient detail so their budgets reflect variation among fields or groups of livestock, rather than assuming that each field or group is equally productive.
One challenge in developing an enterprise budget is to identify and measure all inputs being used, including resources provided by the owners and family members. For example, farmers generally are not paid a regular wage for their efforts and this may cause them to overlook the value of their labor in the analysis. An enterprise that generates $20 of profit and requires 3 hours of the owner's labor may be more desirable than an enterprise that generates $30 of profit but requires 10 hours of the owner's time. Later steps will provide more ideas on how to assess alternatives; but in completing this inventory, farmers are encouraged to specify all resources used to produce their commodities.
The enterprise analysis worksheet (page 4 of the worksheet) contains a line labelled "Accounting Profit (return to owned resources)." The amount in this line is the difference between revenue and the costs that have to be paid. The return is the amount that the farm owner has left, or the amount the farmer earned from having invested in the business. The investments may have been
- equity in land, equipment, buildings, or livestock,
- the owner's labor, and
- the risk exposure the owner accepted.
With this information, the owner can begin to assess whether the return is adequate considering what the owner has invested.
The next several lines on the worksheet (page 4) provide space for the owners to specify a cost they will charge themselves for using some of their investment. For example, farmers may charge a rent for the land they own and use in their business. The cost business owners impose on themselves for the use of their own resources is referred to as opportunity cost . The definition of an opportunity cost often is stated as "the amount of income I am giving up when I use this asset in my business." For land, a question to ask in determining an opportunity cost could be "how much rent am I not receiving because I use my land in my business rather than leasing it to another business owner?"
An alternative definition could be "the amount of income I want to receive in return for using my resource in this activity." This definition allows the asset owner to consider their own values. For example, a farmer may want to receive $10 per hour for operating a crop enterprise but would want $15 per hour to handle livestock, because the farmer does not like animals. Each person likely could present several examples of when they would impose a different opportunity cost depending on the activity in which the resource is being used. Regardless of the definition used, farmers need to understand the cost of using their own resources in their business.
Another question that arises with this analysis is deciding which resource should have an opportunity cost imposed. It does not matter, except if there are particular goals the farmer wants to reach. One suggestion is that the owner could impose an opportunity cost on the resource the owner considers most important in terms of earning a return. Then, any amount remaining after subtracting that cost is the return to the other owned assets.
Example. If the farmer was to charge for the labor the farmer provides to the business, the amount remaining after subtracting an opportunity cost for the labor would be the farmer's return for all other owned assets. The farmer could then ask "if I am paid for my labor, does the business generate enough revenue to justify investing my other assets in the business?"
By imposing a cost for some owned assets, the farmer is better positioned to decide whether to continue or change the current farm operation. This analytical step, however, does not change the amount of revenue the farmer receives since an opportunity cost (labor, in the previous example) does not require a cash payment to another person. This step is only an analytical method to help the farmer better understand the farm business.
Cash Flow for the Enterprise
The last column on the enterprise analysis provides space to indicate the cash flow of operating the enterprise because it will be different than the revenue or costs. For example, harvesting straw after wheat harvest so it can be used as bedding does not generate cash even though it is a product from the enterprise. The straw has value in the revenue column but does not have any amount in the cash column. Depreciation is a cost that does not require cash. Principal payments on debt is an example of a cash outflow that is not a cost. Recognizing these differences helps farmers understand their businesses.
Description of the Enterprise
A budgetary summary is not adequate to fully describe an enterprise. The description also should include a summary of processes used in operating the enterprise. For example, in a livestock enterprise, the summary could indicate the ration, medications, and production technology being used, as well as when each practice is performed. For crop enterprises, the description would likely indicate field operations, the equipment used for each operation, the length of time it takes to complete each operation, when the operation is performed, and whether production of the commodity involves participation in a government program.
Additional information for most enterprises also could address the marketing strategy, the timing of cash flows, risk exposure, and labor needs. Operators who follow a documented marketing plan can include a summary of the plan as part of this section in the manual; otherwise, a brief description of how the commodity is marketed would be a good start. Later steps in the planning process offer an opportunity to refine these strategies/practices. Similarly, quantifying and managing the risk exposure is addressed in a later step.
Timing of Resource Needs
Having resources available when they are needed is a key element to successfully operate any business. Cash flow, labor, and production operations (such as field work) are perhaps the management issues most directly impacted by timing. The following discussion uses cash flow as an example because most farmers are familiar with procedures to analyze whether cash needs match its availability. However, the analytical principles and related issues also apply to labor and production operations.
A cash flow statement provides information as to when cash is needed and when it is received. Generally cash flow statements are developed for the entire farm (a whole-farm analysis) as addressed in a subsequent section. However, to develop a whole-farm analysis, each enterprise is implicitly or explicitly considered. Farmers ask themselves "when am I likely to sell my commodities" and this is usually answered differently for each commodity. Presumably, farmers think about cash flow on an enterprise basis even though they may summarize the information onto one sheet of paper for the entire farm. Page 5 of the worksheet provides space to indicate when the enterprise generates a cash inflow or requires a cash outflow.
Developing a whole-farm cash flow is necessary in order to see the "big picture." But when alternative enterprises are considered (as will be done in step 6 of the planning process), the whole-farm analysis will be partially dismantled to replace the cash flows of discontinued activities with the cash flows of new enterprises. Having documented the cash flow of each enterprise may ease the replacement process because the assumptions made in developing the original cash flow statement would be more explicit. Knowing the timing and size of cash flows are critical in managing a business.
This type of detailed analysis is equally important in assessing the impact of alternatives on the timeliness of labor and production operations. Again, the level of information necessary to develop and document such a thorough understanding of the business will likely take several years to assemble.
Describing the types and timing of labor needs poses many of the same challenges faced in documenting the availability of labor, and thus similar strategies may be beneficial. The same categories could be used for labor needs as were used for labor availability; for example, equipment operator, livestock handler, craftsman/mechanic, and manager. Alternatively, labor needs could be categorized according to whether the activity is indoors (so weather is not much of a factor), outdoors but not involving field work, and field work (perhaps the activity most sensitive to weather).
Farmers find it helpful to use the same measurement for labor needs as they use to document labor availability (such as hours or workdays). Also, distinguishing categories of labor on the basis of time helps assess the adequacy of this critical component. An approach similar to a cash flow statement perhaps can help in understanding the timing issue for labor. A similar timing analysis can be conducted for equipment, building, and land resources.
Later in the planning process, farmers have an opportunity to consider alternative combinations of enterprises. Some of the criteria for selecting enterprises will include profitability (does the enterprise earn an adequate profit) and feasibility (do the cash and non-cash resources necessary to operate the enterprise match with what is available to the business). Recognizing the need for and beginning to gather the detailed information required to answer these questions should ease the process of analyzing alternatives in later steps.
Matching Whole-Farm Resource Availability with Needs
At this point, the farmer has recorded resource availability and resource needs by enterprise, and is now ready to shift back to a whole-farm analysis. However, totaling the dollar amounts or number of units from all enterprise may not be the total for the farm. Some costs or needs that have not been allocated to an enterprise must also be included. For example, the cost of maintaining the farm office or the fee for tax preparation may not have been allocated among enterprises. Similarly, the time necessary to maintain the farmstead or to attend educational meetings may not have been allocated. These unallocated costs/needs should be added to the totals of the enterprises to arrive at a total for the whole-farm.
With the whole-farm totals, the farmer can search for opportunities wherein the enterprises complement one another. For example, a whole-farm cash flow statement that summarizes the cash inflows and outflows, would document that the cash generated with livestock sales would be timely for paying crop production expenses. With this information, the farmer can document when cash needs to be borrowed and when there may be a surplus with which to pay debt, purchase supplies, or meet extra family living costs. Labor can be similarly analyzed; the farmer can determine the amount of labor needed throughout the year and the amount available. By comparing these quantities, the farmer is able to recognize when labor may be in short supply or when there may be some unused time.
The strategies for addressing inadequate or excess supply of a resource will vary depending on the resource. For example, a difference between cash and labor is that cash can be stored and moved from one time period to another by borrowing, repaying, prepaying, and saving. Labor, if not used, is lost. The primary opportunities for managing labor is to hire part-time workers when labor is short and discharge workers or seek alternative employment when labor is not fully utilized. Another practice is to add an enterprise that profitably utilizes excess labor, or perform tasks ahead of time (such as completing equipment maintenance during the winter months). Subsequent steps in the planning process offer opportunities to consider alternative strategies for managing resource availability and needs.
Despite the efforts, a detailed analysis of the match between resource availability and needs often is difficult. It may be best, the first time through this step, to only conduct a preliminary analysis by describing, based on recall of past experience, which resources were in short supply or under-utilized, when during the year the situation arose, the extent to which there was a shortage or surplus, and how the situation was managed. This description then can be enhanced over time as the farmer more closely monitors and records resource mismatches and why they are occurring. Perhaps answering questions such as those listed below would be helpful in preparing a preliminary analysis.
In the past:
- what resources have been in short supply?
- what time of the year were they short?
- why were they in short supply?
- how did you accommodate the shortage?
- what resources were under-utilized?
- what time of the year were they under-utilized?
- why were they under-utilized?
- what did you do to increase their utilization?
Another part of describing the current farm operation is to explain present practices or strategies. Production and marketing strategies/ practices have been described for each enterprise, but there may be other areas that pertain to the overall farm business that have not yet been documented. These could include
- how is the current farm operation financed, how much of the cash operating needs are met by drawing upon savings, how much is being borrowed, who are the creditors, and when is the operating loan normally repaid (financing strategy),
- when are major capital assets acquired, when are they disposed of, how are their purchases financed, and what is the criteria for deciding whether to acquire or dispose of a major asset (capital budget),
- how is available labor being managed; what is the practice for assigning tasks and providing feedback on performance (labor management),
- what strategies are followed for managing risk exposure (risk management),
- what is the owners' strategy for managing income and self-employment taxes (tax management).
Some strategies may be quite informal at this time, but a short description is a first step to developing a more thorough description. Others practices may be quite formal and well-documented. In that case, including a summary of the plan in the manual would be appropriate. Later steps provide an opportunity to refine these practices/strategies into functional plans for future operations.
Another aspect of the current farm is to identify who are the owners of the business; that is, who is authorized to make decisions and who is legally responsible for paying obligations if the farm operation does not generate enough cash to meet all its expenses. A related question is what assets do each of these business owners own? For example, one or two individuals may own a majority of the land while ownership of some equipment is shared by all. In addition, other pieces of equipment may be owned by an individual. A clear record of current ownership can be helpful in understanding the present farm business.
Likewise, the description of the business could include an explanation of how the owners are compensated for their investment in the business. It is not uncommon for the owners to share the profit on the basis of their contributions. However, in other farm business, the owners receive the equivalent of a wage for their labor and divide any remaining profit in proportion to their asset ownership. There are innumerable ways to divide the farm earnings to compensate the owners. This question will be revisited during later steps and initial explanations of current practices will be helpful at that time.
Owners also may want to describe how they assign responsibilities and authorities. In some farm businesses, individuals are identified as being in charge of specified enterprises. In other co-owned farms, the owners hold regular meetings to share information and make collective decisions. Again, the practices vary and are innumerable, but a description of your current practice will be helpful in completing later steps.
Inventory of Financial Assets
Information about the financial results of each enterprise and physical assets does not describe the whole-farm business. An understanding of the farm's overall financial situation requires key financial documents: the balance sheet, the income statement, and the cash flow statement. Financial statements help assess the financial well-being of the overall farm. The whole-farm cash flow statement is discussed in a prior section. This section will introduce the balance sheet and income statement, but focus on how to use the information from these documents.
The balance sheet summarizes the values of the firm's owned assets and liabilities. The difference between the two totals is the owners' equity (net worth). Leased assets are not included in the balance sheet because the farmer does not own them (even though these assets are part of the farm's productive capacity).
One question that arises in preparing a balance sheet is what values should be used. Frequently used valuation methods include:
- historical -- what the asset cost when it was acquired,
- market -- what one could sell it for today,
- replacement -- what one would have to pay to acquire a replacement today,
- book value -- the historical cost minus depreciation.
For various reasons, farmers and their lenders often use market value whereas accountants generally prepare a balance sheet using the asset's book value. An increasingly common practice is to prepare a balance sheet with two columns of values; one for book value and the other for market value.
Some farmers develop more than one balance sheet. One balance sheet is to reflect their business; another balance sheet is prepared for their personal situation. Differentiating between personal and business assets helps to recognize which assets are part of the business and which are outside the business. Two balance sheets also separate business debts from personal debts. Similarly, it may be necessary to prepare several balance sheets to show the portion of the farm that is attributable to a co-owner of the business.
A completed balance sheet shows information, such as the total value of assets, total indebtedness, equity, available cash, and value of liquid assets. This information can then be analyzed to determine the business' current ratio, its borrowing capacity, and opportunities to attract equity capital. It also provides insight into the business' capacity to assume risk.
An income statement reports the amount of profit the business generates. Usually income statements are prepared on an annual basis. An accrual income statement often provides a better measure of the farm's performance because it considers changes in inventory, rather than only cash transactions. It is for this and other reasons why an income tax return should not be relied on as measuring the farm's profit.
A cash flow statement reports the sources and uses of the business' cash resources. Such statements not only show the change in the farm's cash resources over the year, but also when the cash was received or spent. As discussed previously, an understanding of the timing of cash receipts and expenditures is critical in managing the whole-farm. Neither an income tax return nor an income statement provide the same information as a cash flow statement.
The discussion on this page assumes that the financial management expertise necessary to compile these statements is available to the farmer. Likewise, detailed explanations of these statements are available from numerous sources, such as
Management consultants and adult farm management instructors also are sources of such information or expertise.
Using the Information from Financial Statements
Compiling the financial documents from the past years is useful because they reveal trends or patterns. Comparing the current statements to past statements reveal what has been happening to the business' financial situation. The balance sheets show changes in owner's equity and risk exposure (whether they have been increasing, decreasing, or remaining the same); the income statements reveal trends in profit; the cash flow statements can help the farmer understand the timing of cash availability and needs.
The three financial statements also can be used to prepare financial ratios that show the strength of the business. Common financial measures include the firm's debt/asset ratio, return on farm assets, and net farm income. The Farm Financial Standards Task Force has developed standardized farm financial factors, measures, and reporting formats that farmers can use to understand their farm business. These standards are summarized on pages 7 through 9 of the pdf file of this NDSU report. The solvency ratios, for example, reveal the business' level of exposure to financial risk.
The financial ratios can be used to make several comparisons. First, the current performance of the farm can be compared with its historical performance. Second, the farm's performance can be compared to that of similar farm businesses. Numerous public and private sources of farm financial information that can be used to compare the farm business are becoming available. Agricultural Economics Report "Financial Benchmarks of North Dakota Farm Operators: 1993 Update" North Dakota State University, is one source of such information.
A third relationship is to compare the performance or profitability of the enterprises within the farm business. A fourth comparison is to relate the performance of the business to what had been previously projected or budgeted. This comparison helps farmers understand how and why the actual outcome of the business differs from what they had expected. A fifth comparison can be made between the performance of the farm business and non-farm alternatives. This last comparison identifies opportunities, if any, that are lost or relinquished because one has invested their time and capital in owning and operating a farm.
Available Capital and Capacity to Attract Capital
Farm businesses need capital to operate, to enter into new ventures, or to expand the firm. A properly prepared balance sheet reports the amount of cash and other liquid assets available to meet cash needs. However, most businesses have access to more cash than what they currently possess or realize. Nearly all businesses can borrow additional cash, and the capacity to borrow (often called a credit reserve ) is an asset. Similarly, the ability to attract investors is an asset that deserves to be recognized. The capacity to acquire additional cash allows a business to undertake new or expanded activities.
Assessing a business' ability to attract additional capital may be difficult without someone who is willing to lend or invest. The financial ratios and how they compare to similar farms provide some indication of the business' credit reserve. Likewise, a visit with a lender may offer insight into the size of a farm's credit reserve.
Implicit in this consideration is the cost of capital, that is, the rate of interest the business must pay a lender or the return that must be paid to an investor. The higher the interest or dividend rate, the less capacity the firm has to acquire additional capital; thus the market interest rate directly influences a business' credit reserve.
Capacity to Assume Risk
The opportunity for the business to earn a profit requires assuming some risk. Although not described as a business asset, the ability and willingness to assume risk is critical. Types of risk a farm business encounters include production, price, and financial. A farm likely will differ in its capacity to assume each type of risk exposure.
Ability (or capacity ) to assume risk differs from a willingness to assume risk, but either can limit the risk exposure a firm accepts. A farmer's willingness to assume risk is discussed in the next step-- Skills and Interests . Farmers who recognize and prudently use their capacity to assume risk are likely to enhance their chance for financial success.
One way to consider a farm's capacity to assume risk is to describe it as a chain with five links.
- The first link is net earnings as a percent of the value of the farm production, which shows the farm's capacity to absorb losses resulting from reduction in yields or price.
- The second link is the working capital of the farm business; this indicates if the business has sufficient cash flow (and current assets) to cover operating losses that occur in the first link.
- The third link is current debt repayment capacity, which shows the farm's ability to rely on a carryover operating loan to finance operating losses.
- The fourth link is owner's equity, which is the business' ability to sell assets to restructure its finances.
- The last link is collateral, which is the legal right to the owner's equity.
If any one of these links is weak, so is the chain; that is, the farm's capacity to assume risk.
Related to the ability to assume risk is the desire or willingness to control risk exposure through insurance or alternative strategies. Perhaps one rule of thumb on assuming risk could be "if the activity prevents you from sleeping at night, you may not want to pursue it." Methods of assessing and controlling risk are explored in subsequent steps.
The last step in describing the current farm operation may be to document a few of your thoughts, overall reaction, feelings, or observations about the current business. Questions to consider may include
- which activities have been most successful for you?
- are there areas of the business you would like to expand or discontinue?
- what are the strengths of the business?
- what are the weaknesses of the business?