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CHAPTER 10 Analyzing Financial Position and Financial Performance Key Terms Accrual adjusted net farm income Asset turnover ratio Capital replacement and term debt repayment margin Cash flow projections Comparative financial statements Current ratio Debt to assets ratio Debt to equity ratio Depreciation expense ratio Equity to assets ratio Financial efficiency Horizontal analysis Interest expense ratio Liquidity Net farm income from operations ratio Operating expense ratio Operating profit margin ratio Profitability Rate of return on farm assets Rate of return on farm equity Repayment capacity Solvency Term debt and capital lease coverage ratio Trend analysis Working capital In Chapters 1 through 9, you learned how to prepare accrual-adjusted farm financial statements and how to measure and value revenues, expenses, assets, liabilities, and equity items. This chapter focuses on evaluating the financial performance and financial position of a farm operation. You will learn about comparative financial statements and how to conduct horizontal and vertical analyses. You will learn the definitions of liquidity, solvency, repayment capacity, profitability, and financial efficiency and how to analyze each of these areas of a farm business. As mentioned in Chapter 1, financial statements should provide feedback on the decisions made by the farm owner or manager. The techniques in this chapter show you how to obtain the feedback from the financial statements. The accounting procedures outlined in this book provide guidelines that agri cultural producers can use as an alternative to GAAP procedures. The financial statements and disclosure notes prepared according to the FFSC Guidelines are intended to evaluate the financial position and financial performance of agricultural operations by producers, lenders, and other interested parties. Financial statements not prepared according to GAAP or the FFSC Guidelines can misstate the financial position or financial performance of a farm operation, and can inhibit comparing one farm to another. You have learned that one of the primary features of GAAP and the FFSC Guidelines is adhering to reporting revenue when earned and reporting expenses when incurred (the matching concept). Matching is accomplished using the accrual- basis system recommended in GAAP and the accrual-adjusted approach recommended in the FFSC Guidelines. Financial statements prepared under a

Learning Objective 1 To define “comparative financial statements” and conduct a horizontal analysis and trend analysis. cash-basis system might not report revenues and expenses in the period in which they occur. Because selling farm products and paying for expenses can occur at different times from year to year, comparisons from one year to the next may be difficult. Financial statements prepared using accrual-basis accounting or the accrual-adjusted approach alleviate that problem by reporting revenues when earned and expenses when occurred, instead of when cash is paid or received. In addi tion, using the measurement and valuation procedures in the FFSC Guidelines contributes to consistent reporting from one year to the next and from one farm to the next. Lenders and agricultural producers recognize that other factors besides financial information will play a role in analyzing the health o fa farm business. These factors are as varied as the nature of each farm operation, its strengths and weaknesses, and its management. This chapter concerns financial indicators to use in evaluating virtually any farm operation. Although some indicators for evaluating a farm operation might be more important than others, the financial indicators discussed in this chapter are universal in nature. The individual producer or other interested parties decide on the usefulness of each indicator for the farm operation. COMPARATIVE FINANCIAL STATEMENTS Comparative financial statements provide one way to evaluate the financial health of a farm business. They consist of statements with more than one year of data. The current year's data is presented alongside the previous year's data, as shown in Table 10-1. When financial statements are prepared for the current year, the financial statements will also include the line items on each statement for the previous year in side-by-side vertical columns. Presenting the information in this manner helps producers and lenders compare the current year's financial position and perform ance with previous years. Comparative financial statements can be used for horizontal analysis. Horizontal analysis is using percentage changes of financial items to assess improvement. Horizontal analysis involves: ■ Calculating the percentage changes of each item on the financial statements. • subtract the amount from the previous year from the current year's amount • divide the difference by the amount from the previous year ■ Evaluating the results. Percentage changes of key items can reveal whether or not the financial per formance has improved over time. For example, a percentage increase in accounts payable might suggest problems with paying bills. Percentage changes can be useful, but can also be misleading. If net income, for example, is quite low or negative in a given year because of an extraordinary loss, and returns to normal levels the fol lowing year, the percentage change will be quite drastic. Readers of the financial statements should understand the nature of individual items, to avoid being misled by such abnormalities.

TABLE 10-1 ■ Farmers' Partial Comparative Income Statements and Balance Sheets. INC0ME STATEMENT 20X2 20X1 Gross Revenues $79,600.00 $81,050.00 Operating Expenses (46,800.00) (31,564.20)- __ Net Farm Income from Operations 32,800.00 49,485.80 Loss on Sales of Farm Capital Assets 0 (800.00) Income before Taxes 32,800.00 48,685.80 Total Income Tax Expense (Farm Business Only) (6,500.00) (7,700.00) Accrual Adjusted Net Income $26,300.00 $40,905.80 20X2 BALANC E 20X1 SHEET 20X2 20X1 Assets: Liabilities: Total Current Liabilities $ 45,500.00 $ 59,820.00 Total Current Assets $ 17,800.00 $ 16,403.80 Total Non-Current Liab. 145,000.00 206,168.0 0 Total Liabilities 190,500.00 265,988.0 0 Equity: Retained Capital 561,700.00 495,615.8 0 Valuation Equity 10,950.00 11,650.0 0 Total Non-Current Assets 745,350.00 756,850.00 Total Equity 572,650.00 507,265.8 0 Total Assets $763,150.00 $773,253.80 Total Liabilities and Equity $763,150.00 $773,253. 80 The Farmers conducted a horizontal analysis on their income statement after they prepared the financial statements for 20X2. They decided to conduct the analysis on gross revenues, operating expenses, net farm income from operations, income before taxes, total income tax expense, and accrual adjusted net income. Year 2 minus Year 1 Divide by Year 1 Percentage changes for: Gross Revenues = [79,600 - 81,050] = -1.8% + 81,050

Operating Expenses = [46,800 - 31,564] = +48% + 31,564 Net Farm Operating Income = [32,800 - 49,486] = -34% + 49,486 Income before Taxes = [ 32,800 - 48,686] + 48,686 = -33%

Income Tax Expense = [6,500 - 7.780] + 7,780 =-16% Accrual Adjusted Net Income = [26,300 - 40,906] + 40,906 = -36% Income Statement 20X2 20X1 Percentage Change Gross Revenues $79,600.00 $81,050.00 - 1.8% Operating Expenses (46,800.00) (31,564.20) +49% Net Farm Income from Operations 32,800.00 49,485.80 -34% Loss on Sales of Farm Capital Assets 0 (800.00) Income before Taxes 32,800.00 48,685.80 -33% Total Income Tax Expense (Farm Business Only) (6,500.00) (7,780.00) -16% Accrual Adjusted Net Income $26,300.00 $40,905.80 - 36% Exercise 10-1 Can you evaluate the results of the Farmers' horizontal analysis? How did the farm busi ness perform in 20X2 compared to 20X1? Answer: Clearly, the farm business produced less profit in 20X2 compared to 20X1. The revenues and the net farm operating income, income before taxes, and accrual adjusted net income decreased from the previous year. We can attribute the decrease in these numbers mostly to the increase in operating expenses. Trend analysis is calculating the percentage change from a base year. ■ The amount for each of the line items in the first year's financial statements is the base figure for that item. ■ In each subsequent year, each line item on the financial statements is divided by the corresponding line item on the first year's financial statements. The purpose of the trend analysis is to check the overall trend. Examining the overall trend helps evaluate the general direction of the farm's performance. The percentages indicate whether or not the farm operation is improving financially. This technique can also alleviate distortions that can result from looking at per centage changes only from one year to the next. Suppose that for the Farmers, their first year of operation is the year 20X1. T he amounts for each of the line items in the 20X1 financial statements are the base figures. For accrual-adjusted net income, for example, each subsequent year's accrual-adjusted net income is divided by the accrual adjusted net income for 20X1. Accrual Adjusted Net Income 20X1 $40,906 20X2 $26,300 20X3 $43,685 20X4 $47,395

Learning Objective 2 To define “liquidity,” “solvency,” “repayment capacity,” “profitability,” and “financial efficiency”. =64% Exercise 10·2 Can you evaluate the results of the Farmers' trend analysis? How is the farm business performing over time? Answer: With the exception of 20X2, accrual adjusted net income is on an upward trend, with 20X3 and 20X4 reporting an increase over 20X1. The increase in 20X4 is greater than the increase in 20X3, further indicating an upward trend. Horizontal analysis and trend analysis enable comparison of the farm operation over time. For the lender, these techniques allow for comparisons with other farm operations. P R A C T ICE WH AT YOU H A VE LE A RNED . Practice these techniques by completing Problem 10-1 at the end of the chapter. FINANCIAL RATIOS Typically, a farm operation has obligations to outside parties ( creditors ) . Creditors are interested in measuring the ability of the farm business to pay its debts. The owners of the farm business are interested in measuring the profitability of the farm business and the return on the owners' investment. In addition to horizontal and trend analysis, owners and creditors can use various financial ratios to measure financial performance and financial position. They are interested in different types of ratios that pertain to their particular interests. A financial ratio is a mathematical relationship of one financial item to another. They are especially useful for comparing information from one farm operation to another farm operation or from one year to another year for a single farm operation. Financial ratios level the playing field for making reasonable comparisons. For an example, see Table 10- 2. TABLE 10-2 ■ Two Different Sized Farm Operations. Farm A Farm B Accrual Adjusted Net Income Total Assets $ 50,000 $400,000 Trend Analysis: Current Year + 20X1 20X2: =26,300 ...,.. 40,906 20X3: =43,685 ...,.. 40,906 =107% 20X4: =47,395 + 40,906 =116%

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