To grow, look to your financial statements
Author: Mark Verwey
Date: January 2011
Publication: Country Guide
A bad decision can cripple a farm immediately and the effects may linger for many years. With the cost of land and equipment increasing astronomically and profit margins narrowing, you must carefully think out every decision, especially those involving expansion and growth. You must thoroughly understand your current financial situation and the impact of any major purchase.
Follow these three important steps to properly assess any expansion:
1) Manage your balance sheet to grow your equity
Your balance sheet is a snapshot of your business at a point in time. Your lending institution will use the balance sheet to assess whether you have enough assets for collateral to cover existing and new debt. An expansion will increase both your assets and your debt load. Shareholders’ equity is the value of your assets less your liabilities. The higher the equity, the better off you are financially.
The top half of Table 1 illustrates a balance sheet as at December 31, 2009 and 2010.
2) Appreciate the importance of your statement of operations
Your statement of operations records your revenue and expenses for the year and should be designed to give you the most information possible. The income statement in Table 1 uses a contribution-margin format showing revenue from crops produced that year minus direct production expenses. The higher your contribution margin, the higher your profits. Concentrate on improving this aspect of your farming operation first. Measure your contribution margin against previous years and the industry average to assess your performance. A profitable operation is essential to service existing and new debt.
3) Look through the eyes of your lender.
Your lending institution has guidelines that they must measure when providing financing, and of these, the debt-service ratio is often considered the most important measurement tool. New assets such as land and equipment must generate enough additional income to pay off the related debt, and the debt service ratio provides assurance that the farm can meet its obligations. The debt service ratio is calculated as: (net income + amortization + interest costs) / (annual principal payments + interest costs)
Using your statement of operations and current annual principal payment requirements, calculate your debt service ratio prior to any contemplated expansion. Next, take a hard look at how your financial situation will change given your plans to expand.
This includes additional debt servicing requirements. Equally important, it should identify how you anticipate this investment will improve your bottom line profit. With these new numbers, recalculate your debt service ratio. Before and after, the debt service ratio must be acceptable to your financial institution.
An investor would never buy an investment knowing it will decline in value. Similarly, a producer should never make a significant farm-related investment without some certainty that their financial situation will be improved.
Mark Verwey is a partner of BDO Canada LLP and Manitoba representative of the firm’s agricultural group.
He provides accounting, taxation, succession, estate planning and consulting services to clients including
agribusinesses and primary producers. You can reach
Mark in the Portage la Prairie, MB. office at mverwey@bdo.ca o r204 857 2856
