By Paul Kuntz
As a financial consultant in the agriculture world, I do have a favourite financial statement. I realize this is not an area that is very exciting but even when it comes to something boring, you can still have favourites.
When I worked in the lending industry, I would often argue with my bosses over the importance of the balance sheet over the income/expense statement. My superiors would argue that the farm has to make a profit. I do agree that profit is a wonderful part of a business but it is not always necessary to be successful.
If you farmed any time from 1985-2007, there were years (maybe many years) where you did not have any profit on your farm. This is not to say that from 2007 to 2018 profit has been guaranteed on your farm. I am speaking generally in the agriculture industry. There was a time when you had no cash left over (or you were short of cash) year over year. Equity was built. Assets were purchased. Income was perhaps earned from off the farm. This was how you survived.
From the years I have spent analyzing financial statements, the balance sheet is what truly shows management. It is important to make a profit, but it is more important to manage that profit. Your balance sheet shows what you did with that money each year. It shows if you have reinvested it or if you have removed it.
There has been an industry argument in the lending world about land valuation and what that does to the balance sheet. When land prices started to move drastically, some lenders did not want to show those prices as they felt it was distorting the ratios. I heard lenders say that the improvement in the farmer’s financial position had nothing to do with the farmer, it just happened that the land value went up. My argument is that the farmer was smart enough to own land at a time when it appreciated in value. Even though the farmer did not buy the land as a speculative purchase, we cannot punish the producer for making a great real estate investment. Perhaps adjustments can be made to measure year-over-year improvements without the land value increasing. At the end of the day, the land is worth what the land is worth.
A market value balance sheet is the real report card as to where your operation is right now and how well you have fared over the years. A profit/loss or income statement is what happened in the last 12 months. I am more interested in the long-term picture of the operation.
This is the time of year when you can do this analysis. You should do this exercise as of your year-end date. Do not rely on your accountant’s balance sheet if they prepare one for you. This document is not a real balance sheet that measures your true worth. You need to do this on your own.
Start by listing your assets. The list should go from the most liquid to the least liquid. You begin with cash, then grain inventory, deferred grain, prepaid inputs, market livestock, feed and accounts receivable. This list will be called current assets. Then you can list machinery, breeding livestock, buildings, land and RRSPs. These are long-term assets.
Across the column you will list your liabilities in the same fashion: start with what is due now to what is due much later. You would begin by listing your lines of credit, accounts for fertilizer-chemical-seed-fuel, operating loans and accounts payable. You would also add the portion of your long-term debt that is due in the next 12 months. This is basically the payments for the next year. These debts will be classified as current liabilities. Then you can list your equipment loans, cattle loans, building loans and land mortgages. Make sure to adjust for the payments due this year that you included in the previous category. This will be your long-term debts.
Then you can add up all of your assets and your liabilities. The difference will be your net worth. This will be your market value balance sheet. This will measure how viable your farm is on the short term and long term.
You are now able to look at some ratios that will help measure your financial health. If you look at the total liabilities versus the net worth you get your debt/equity ratio. If this number is close to 1:1, you are a higher risk for the banks. Lenders want to see this number around .65:1. This ratio measures long-term viability. It seems hard to believe that for a grain or cattle operation, if your farm is half paid for, you are considered risky. A 1:1 debt/equity ratio means 50 per cent of your farm is yours. That is the reality though in the lending world.
If you relate your current assets to your current liabilities, you will get your current ratio. This measures your short-term viability. Lenders want to see a ratio of 1.5:1 or better. They want to see that for every $1 of current liabilities you owe, you have $1.50 in available current assets to pay. This is an area where I will see farms build up a larger current position and by doing so, they can weather a few storms. These farms can actually produce less than their cost of production and be perfectly fine because they have a strong current position from previous years.
Taking a close look at a market value balance sheet is not something that a lot of producers do. If you owe money, I guarantee that some lender looks at it. I would highly recommend that you look at it on your own and do your own analysis. Measure your numbers. Record this data. Compare it year over year. Keep your asset values up to date. Do not rely upon a banker to do your analysis for you; do your own. It is winter on the Prairies and it is a great time to pour a cup of coffee, let the sun shine into your office/kitchen, and do a balance sheet analysis of your operation.