A Financial Analysis Program That Will PASS the Farm

Manager “Interest Test”

By Christine Wilson, Freddie Barnard, and Michael Boehlje

Background

Effective financial management is essential to the success of an agricultural business, so

farm managers, whether professional fee for hire managers, entrepreneurs managing

their own farm businesses, or salaried managers of farming businesses, should be

interested in programs that analyze the financial aspects of their businesses without

encouragement from lenders, consultants, and others. However, anyone who has worked

with farm managers can relate to how difficult it is to get some of them to not only use,

but to even express an interest in, such programs. Farm managers seem to have an

internal “interest test” that is administered when weighing the benefits and costs of

using, and in some cases even considering, such programs.

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Abstract

This paper discusses a farm

financial analysis program,

along with four features of the

program that have facilitated its

use by farm managers. The four

features that appear to increase

farm manager interest in the

program are Performancebased,

Accrual-adjusted income

statement, System of financial

analysis, and Simple to use. We

illustrate this program with

application to a farm firm case

study.

Christine Wilson is an associate professor in the Department of Agricultural

Economics at Purdue University. She teaches undergraduate courses in marketing

management and accounting/finance for farm business planning. Dr. Wilson’s

research and Extension interests include the areas of farm and agribusiness marketing

and management and agricultural finance.

Freddie Barnard is a professor and Extension economist in the Department of

Agricultural Economics at Purdue University. He is also a member of the Technical

Committee of the Farm Financial Standards Council. Dr. Barnard is involved in

teaching and Extension in agricultural finance, farm and agribusiness management.

Michael Boehlje is a professor in the Department of Agricultural Economics and the

Center for Food and Agricultural Business (CAB) at Purdue University. Dr. Boehlje is

involved in teaching and research in agricultural finance, farm and business strategy

and management and structural change in the agricultural industries.

At least four program features appear to be included in the

“interest test.” The four can be represented by the acronym

PASS, which stands for Performance-based analysis, Accrualadjusted

income statement, System of financial analysis, and

Simple to use. These features refer to the capability of a farm

financial analysis program to evaluate the financial performance

of the business by using information reported on an accrualadjusted

income statement to calculate the financial ratios

recommended by the Farm Financial Standards Council (FFSC).

Once that has been accomplished, the program should have the

capability to compare those financial measures to comparative

data for the industry, identify the strengths and weaknesses of

the business, determine causes of the weaknesses, and identify

alternatives to address those weaknesses. The program should

then have the capability to evaluate production, marketing, and

financing alternatives that are identified as possible solutions.

Furthermore, the program should be simple to use and have the

capability to generate the outputs listed above using data the

manager currently has in his/her possession. This last feature

may be the most important for many farm managers.

The above list of features can be difficult to satisfy. However, a

financial analysis program available from Purdue University

appears to satisfy the list for at least some farm managers. The

remainder of this article discusses the features of the program

that have helped it PASS the “interest test” given by some farm

managers.

Performance-based Analysis

Performance-based analysis includes not only the preparation of

the basic financial statements (balance sheet and income

statement), but also how to use data reported on those

statements to calculate financial performance measures that can

then be compared to industry averages for farms with similar

characteristics. The program available from Purdue University

is discussed in an Extension publication Farm Business

Management for the 21st Century: Measuring and Assessing

Farm Financial Performance (EC-712). Guidelines provided by

the FFSC are used to prepare the financial statements and

calculate the financial measures. The financial measures for an

individual farm are then compared to either benchmarks or

industry averages. Comparative industry data are available from

state record-keeping programs in Illinois, Iowa, Kentucky, and

Minnesota.

Accrual-adjusted Income Statement

The benefits of using financial data reported on an accrualadjusted

income statement for purposes of farm financial

analysis are well documented. The magnitude of the difference

between net farm income calculated using a cash basis income

statement and net farm income calculated using an accrualadjusted

income statement is reported in two studies conducted

at the University of Illinois for Farm Business and Farm

Management (FBFM) data (Lins and Ellinger, Ellinger). The

first study found an average 69.7 annual percentage difference

between the two net income figures for 369 farms over a sevenyear

period (1984-1990). The second study, conducted in 2004,

reported that three-year average income tax return measures

deviate 24 percent from three-year average accrual-based

profitability measures.

Although farm managers usually acknowledge the benefits

associated with using an accrual-adjusted income statement for

financial analyses, the challenge for many is the preparation of

that statement. The program discussed in this article prepares it

automatically after the user inputs data from three or four

documents he/she should possess.

To use the program, producers need a balance sheet that is

prepared at the same time each year, the Schedule F, and, if

applicable, the Form 4797 of the income tax return. The date of

the balance sheet is determined by the tax reporting period for

the business. For many agricultural businesses, that date is the

end of the calendar year or December 31st. If a business is on a

fiscal year that is different from the calendar year, then the

balance sheet should be prepared as of the start and end of the

fiscal year.

Data required by the computer program include data reported

on the beginning and end-of-year balance sheets to make

accrual adjustments in order to prepare an accrual-adjusted

income statement (i.e., beginning and ending inventories,

accounts receivable, accounts payable, accrued expenses, etc.).

The cash transactions and the depreciation expense are taken

from the Schedule F, and the gain or loss from the disposal of

capital assets is taken from the Form 4797, if applicable. Of

course, tax basis depreciation is usually taken at an accelerated

rate and can result in overstating the economic depreciation.

Farm managers can either use the tax basis depreciation or an

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estimate of economic depreciation as calculated by the manager.

Once that information has been entered, an accrual-adjusted

income statement is automatically generated by the computer

program.

System of Financial Analysis

A systems approach to evaluate performance, including

financial performance, is used throughout agriculture. The

DuPont Financial Analysis System, which is also known as the

profitability linkage model, is a financial analysis system that

can link production, marketing, and financing decisions to

financial performance through financial ratios. Various

production, marketing, and financing alternatives can be

identified using the financial ratios calculated and comparative

data for the industry, and the likely causes and possible

alternatives for addressing business weaknesses can be

identified. The impact of each alternative can then be evaluated

using the DuPont Financial Analysis System. The analysis is

based on the relationship that exists among three key financial

ratios: operating profit margin; asset turnover; and leverage

(total farm assets/owner’s equity).

When the three ratios are multiplied together, and the interest

cost adjustment is made, the result is the rate of return on farm

equity (Barnard and Boehlje, 2004).

Simple to Use

The program includes a set of four worksheets (1-4) that

provide a simple, step-by-step procedure for entering financial

data (Barnard and Boehlje, 2003). Worksheet 1 is used to

collect and organize information from beginning and end-ofyear

balance sheets, Schedule F, and if filed, Form 4797 from

the income tax return. Each line on Worksheet 1 is labeled with

a letter. For example, the first line is labeled with an A and

reports the cost of livestock sold. Next, instructions are

provided to assist users in locating the information (i.e.,

Schedule F, line 2). Lines A through F are used to input data

collected from the Schedule F, with instructions for locating

each number on the Schedule F. Other lines collect information

reported on the beginning and end-of-year balance sheets as

well as other information (i.e., sale of breeding livestock from

Form 4797, family living expenses, and number of full-time

employees).

Worksheet 2 is used to calculate the financial measures

recommended by the FFSC. It uses information reported on

Worksheet 1 to perform the calculations automatically. Also

provided on Worksheet 2 are industry benchmarks or averages.

Industry averages are available from various farm records

programs (i.e., Illinois FBFM, Iowa State Farm Records

Program, etc.) for selected financial performance measures. The

computer program automatically compares the financial

measures calculated for an individual business to the industry

average. The strengths and weaknesses for the business are

automatically highlighted. The possible courses of action

available to address areas identified as weaknesses are available

from a list provided in the EC-712 publication (Table 1) and

discussed by Barnard and Boehlje (1998-1999). Managers can

then formulate production, marketing and financing alternatives

to address weaknesses, and improve financial performance.

Worksheet 3 is used to calculate the repayment capacity

measures recommended by the FFSC. The calculations for the

measures are simplified, because the numbers are transferred

from Worksheet 1 and the producer only provides a limited

number of entries (i.e., scheduled principal and interest

payments on term debt and capital leases and cash purchases for

capital replacement). In addition, when the term debt repayment

margin is calculated, participants can estimate the amount of

additional debt that could be serviced by that margin. An

amortization table is provided in the program. When the term

debt repayment margin is divided by the amortization factor

corresponding to the interest rate and number of years being

considered for an additional loan request, the result is the

maximum amount of additional debt the operation could

service.