It’s that Time of Year Again
I know everyone is probably focused on calving and looking forward to little paychecks hitting the ground. But, it’s also that other time of year, tax season. While tax preparation generally leads to added stress and frantic scrambling to try to reduce our tax burden, it does offer at least one benefit. It forces us to take a look at the business side of our operation.
While I recommend generating a full set of financial statements every year to gauge the health of your business, at least tax preparation requires a Schedule F. It may be tempting to look at this as a true income statement, but that can be dangerous. A good accountant will work to decrease your tax burden, which can skew some of the numbers on a Schedule F. To use the information in analysis and decision-making, you should convert your Schedule F into an accrual-based income statement.
You can transform your information by following some pretty simple directions, found at extension.iastate.edu/agdm/wholefarm/pdf/c3-25.pdf. I would also assume your accountant could prepare that statement relatively inexpensively for you. When generating an income statement, it is especially helpful to have one that separates revenues and expenses by enterprise.
So why do we need an accrual based income statement? Remember those last-minute trips to the co-op in December? By prepurchasing inputs for next year’s operations, like feed, fertilizer, fencing materials, etc., we were able to decrease our current year’s income and decrease our current tax liability.
The problem with simply using a Schedule F to determine profitably of your operation is that those prepaid expenses were included in your 2016 tax calculations, but in reality, those costs should be charged against this year’s operations.
By adjusting the Schedule F, we can look at costs and revenues in the correct years. This is especially important when looking at trends over time.
Why do we want to calculate revenues and expenses by enterprise? By understanding how our different enterprises – whether that be calves, heifer development, haying, etc. – contribute to our overall profitability, we can look for activities that may be able to help us become more profitable through increased investment or areas where we need to focus to minimize expenses.
This sort of analysis can also help us understand if a given year’s profits were due to normal operations, like selling weaned calves, or uncommon events. For example, culling a large portion of the herd in a drought year would generate a lot of revenue but would be a one-time occurrence resulting in future costs associated with rebuilding.
Further, by determining the profitably of each enterprise, we can compare the operating profit margin ratio across enterprises. This measure simply shows the percent of revenues that ends up as profit.
Often, we have enterprises that generate a lot of revenue but also require a lot of expenses to generate those revenues. When looking to invest money into our business, it can be insightful to see what enterprises generate a better return in regards to this ratio. Enterprises with low revenues may actually have a high profit margin ratio.
And finally, separating enterprises allows us to track how output from one enterprise contributes to other enterprises. For example, separating cows from our heifer development enterprise allows us to track the value of heifer calves from our cowherd and transfer that as a cost to our heifer development enterprise to make sure we can fully account for the cost of retained heifers.
Looking at your profitability last year and accounting for those inputs purchased at years’ end, you can get a better feel for your cash position for the coming year. Projecting cash flows over the coming year can help you determine if you have adequate credit to get you through until weaning this fall.
Given the decline in last year’s revenues, you may need a little larger operating loan this year, and having a good understanding of your profitability and cash needs can help you start the process of talking to the bank.
If you’re willing to take an extra step, I also suggest creating a balance sheet to track how much of your ranch is actually yours. Having a balance sheet allows you to determine how much of your ranch is truly yours, as determined by owner’s equity.
Another major benefit of having a balance sheet is the ability to calculate return on equity and return on assets. These numbers are helpful to show whether leveraging external funds to expand your business is helpful or hurtful to your operation’s health. Understanding these ratios will become more important as we begin to see interest rates rise.
Investments that have been profitable the last few years will become less so as the cost of debt begins to rise. Understanding which investments are likely to become unprofitable can help prevent us from losing money, but we need to know the return on our assets to understand which operations can cover the rising cost of debt.
Creating and analyzing these sorts of statements shouldn’t be a one-time occurrence. The value of creating these statements really is being able to track your business over time. Documenting information without looking both backward and forward to make informed decisions is not a very valuable exercise.
By understanding where we are, in relation to where we’ve been and what we’ve done to get here, we can gain the ability to plan on how best to get to where we want to go.