Five Ways to Make Better Use of Your Financial Statements
By Mark Verwey, CA, R.F.P., CFP
Partner, BDO Dunwoody LLP, Portage la Prairie Office
April, 2008
You would never go to a hockey game and not look at the scoreboard. By the same token you would never conduct business as usual and ignore your financial statements. Properly presented financial statements give you critical information on the performance of your farming enterprise.
Here are five ways to better understand and make use of your financial statements.
1. Recognize the underlying accounting principles that go into preparing your financial statements
The principle of conservatism recognizes that when uncertainty exists, we estimate conservatively to ensure that assets and revenues are not overstated and liabilities and expenses are not understated. It is important to err on the side of caution and not be too overly optimistic, especially when dealing with your lender.
The principle of historical cost implies that all assets remain at their historical cost until the assets are sold. A good example for farming corporations is that land values remain at its historical cost instead of changing each year based on the current fair market value. When reviewing several years of activity it allows one to compare “apples with apples.”
The principle of matching requires that revenues and expenses relating to the same activity are reported in the same accounting period. In accounting terms, the financial statements are prepared on the accrual basis. For decision making this is critical since it ensures that the cost to produce your crop is recorded in the same period as the income from that crop.
2. Manage your balance sheet to grow your net worth
Your balance sheet is a snapshot of your company at a point in time. The top half of Exhibit 1 illustrates a balance sheet as at December 31, 2006 and 2007. Your net worth or shareholders equity is simply the total value of your assets less your liabilities. Your lending institution will use the balance sheet to assess whether you have enough assets (i.e. collateral) to cover existing debt.
Whether you plan to pass the farm onto the next generation or use the assets as a source of retirement, remember that the higher the net worth of the farm, the better off financially you will become. Treating your farm as an investment will also encourage you to track your net worth.
3. Use the good times to rejuvenate your balance sheet
The assets on a balance sheet are broken down between two elements. The first being current assets, which is either cash or assets easily convertible into cash such as inventory and accounts receivable. Secondly, long-term assets are those in which property and equipment make up the biggest component. The liabilities on a balance sheet are also comprised of two elements. Current liabilities would include your operating line of credit, accounts payable, crop advances and principal payments due within the next year. Secondly, long-term liabilities are those in which equipment loans and mortgages make up the biggest component.
One of the key factors to future viability is to ensure current assets exceed current liabilities. Consequences can be grave if the operation does not have the necessary funds to meet obligations due within the next year. Take advantage of the good times when commodity prices are high and use this additional cash injection to pay down current liabilities. This should always be considered before adding to your long term assets though the acquisition of more land or equipment. A strong liquidity position will carry you through the lean times. Being “dirt rich” and “cash poor” may look good on paper, but it is of little value to a demanding creditor.
4. Control from the top
A statement of operations records your revenue and expenses for the year. The bottom half of Exhibit 1 provides an example for the year ended December 31, 2007. This statement should be designed to give you the most information possible. The example provided makes use of a contribution margin which is crop revenue produced that year less direct expenses required to generate that revenue. The dollar amount and percentage of the contribution margin are critical to the success of your company, as higher margins translate into larger profits. Measure this against prior years and the industry average to assess your performance. Concentrate on improving this component of your farming operations first.
5. The proof is in the bottom line
Another key measuring stick on the statement of operations is the amount of income left before management salaries and income taxes. In Exhibit 1 this amounted to $160,000. With this information you then determine how much to pay yourself (i.e. management/family salaries) and how much to leave in the company. In Exhibit 1, after management salaries, $90,000 was left in the company creating a tax expense of $15,000. The remaining amount of $75,000 represents the net income of the company which leads to direct improvement in the net worth or shareholders’ equity of the same amount. It is important to understand the linkage between your balance sheet and statement of operations.
Your financial statements are your report card. Use them to assess what you did well in the previous year, and what areas you need to work on to make your farming operation even more successful. Remember, you can’t manage what you can’t measure.
Exhibit 1
