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A Financial Analysis Program That Will PASS the Farm Manager Interest Test

Source: American Society of Farm Managers and Rural Appraisers, by Christine Wilson, Freddie Barnard, and Michael Boehlje

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.

The DuPont Financial Analysis Program, which is embedded in

Worksheet 4, enables the producer to evaluate the impact on the

return on equity (ROE) of each of the alternatives being

considered. The numbers used for Worksheet 4 are transferred

from the previous worksheets. Revised numbers for each

alternative evaluated are then entered and the result is available

immediately. Worksheet 4 is designed so that numerous

alternatives can be evaluated in a very short period of time.

Case Example

A case example farm, MBC Farms, is used to illustrate how to

complete and use the program. MBC Farms is a dairy-crop

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operation and has beginning (12/31/20X4) and end-of-year

(12/31/20X5) balance sheets, a Schedule F for 20X5, and a

Form 4797 that reports the gain from the sale of cull cows

received during 20X5. Information taken from those four forms

is entered onto Worksheet 1, along with the number of full-time

employees (8) and the combined amount of family living

expenses withdrawn from the farm ($141,087) during 20X5.

The accrual-adjusted gross revenues, interest expense, other

expenses and net farm income amounts are automatically

calculated by the spreadsheet and shown on lines W-Z.

Next, eleven financial measures are automatically calculated

using the numbers from Worksheet 1. The results are shown on

Worksheet 2, along with benchmarks for the dairy enterprise.

The benchmarks used in the worksheet are the median values

for Illinois dairy farms for 2004 and reported in the 2004

Financial Characteristics of Illinois Farms. Of course, the

benchmarks could come from other farm record-keeping

programs and other sources as the user desires. The program

automatically compares the eleven financial measures for MBC

Farms to the benchmarks and indicates whether the measure is

strong or weak compared to the benchmark. As can be seen by

reviewing Worksheet 2, the return on assets and asset turnover

measures are strong compared to the benchmarks and all other

measures are weak. Hence, the troubleshooting procedure will

focus on operating efficiency rather than on the intensity of

asset use. So, the user can then use the list of possible courses

of action from Table 1 to identify possible alternatives to

evaluate.

The numbers used to complete Worksheet 3 are automatically

transferred from Worksheet 1, except for the cash used for

capital replacement and the scheduled principal and interest

payments on term debt, which come from the farm records for

MBC Farms. The term debt coverage ratio (1.558) and the term

debt repayment margin ($95,355) are calculated automatically

by the spreadsheet. At the bottom of Worksheet 3, the interest

rate and years to repay term debt are entered for a loan request

being considered in order to calculate the additional term debt

that the term debt margin ($95,355) could service, which was

calculated to be $370,898. The user can use the entire amount

of the term debt repayment margin in the calculation or a

portion of the margin if they desire to maintain a cushion for

debt service.

Two charts are also available in the program. The first chart

presents operating expenses, depreciation expense, interest

expense, and net farm income as a percentage of gross revenue.

When all four components are summed, the total equals 100

percent. Also, presented on the chart are the benchmarks for

each of those four components of revenue. This presentation of

the data enables the user to visually compare each component

of revenue to benchmarks for that measure.

The second chart compares profitability measures, actual to a

benchmark. If the actual profitability measure equals the

benchmark, the comparison is 100 percent. If the actual exceeds

the benchmark, the percentage the actual exceeds the

benchmark is presented as a percentage greater than 100

percent. If the actual is lower than the benchmark, the bar chart

indicates the percentage actual is lower than the benchmark.

The profitability linkage model for MBC Farms is automatically

calculated and reported as the actual column on Worksheet 4.

To illustrate how to use the profitability linkage model, two

alternatives are evaluated for MBC Farms: early planting and a

reduction in the interest cost. The expected impact of planting

earlier is an increase in yield, which is expected to increase

gross revenues. The increase in gross revenues is entered in the

projected column, while the other entries remain the same as the

original situation. The results of planting earlier are shown in

the projected column, which are to increase both operating

profit margin and asset turnover compared to the original

situation. The increases in those two measures increase the rate

of return on assets and ultimately the rate of return on equity

from 10.8 to 13.6 percent, or a 2.8 percentage point increase.

A second alternative, reducing the interest cost, is evaluated

next and the results are reported in Worksheet 4. For this

alternative, only the interest cost is changed from $98,716 to

$89,744, which decreases fixed costs by $8,972. None of the

other entries need to be changed from the original situation to

evaluate the impact of reducing the interest cost. The effect of

reducing the interest cost is to decrease the interest cost

adjustment (line D, Worksheet 4). The result is 11.5 percent

return on equity, which is only 0.7 percentage point higher than

the original situation. Hence, the manager for MBC Farms

knows the impact of planting earlier will likely have a more

measurable impact than trying to reduce the interest cost.

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Additional alternatives can be evaluated by changing a limited

number of entries and the impacts compared to the original

situation. It should be noted that two alternatives were evaluated

for MBC Farms by changing only two data entries: one for

alternative 1 and one for alternative 2. A desirable feature of

this program is that a number of alternatives can be evaluated

with few data entries and in a short period of time.

Final Comments

Several farm financial analysis programs are available and

provide a comprehensive and thorough analysis of an

agricultural business. However, one of the greatest challenges

faced by farm managers is to find a program that provides a

thorough analysis, uses data managers have in their possession,

and is simple to use. In other words, a program that will PASS

the farm manager “interest test.” A farm financial analysis

program that has PASSed the “interest test” administered by

some farm managers is available at http://www.agecon.

purdue.edu/extension/programs/fbm21/perform.htm. The

program can be downloaded at no charge.

References

Barnard, F. L. and M. Boehlje. “The Financial Troubleshooting

of Farm Businesses: A Diagnostic and Evaluation System

(DES).” Journal of the American Society of Farm Managers

and Rural Appraisers. (1998-1999): 6-14.

Barnard, F. L. and M. Boehlje. “Using Farm Financial

Standards Council Recommendations in the Profitability

Linkage Model: The ROA Dilemma.” Journal of the American

Society of Farm Managers and Rural Appraisers. (2004): 7-11

.

Barnard, F. L., and M. Boehlje. “Worksheets That Work for

Measuring and Assessing Farm Financial Performance.”

Journal of Extension. Volume 41, Number 6 (December 2003).

Boehlje, M., C. Dobbins, A. Miller, D. Miller, and F. Barnard.

Farm Business Management for the 21st Century: Measuring

and Analyzing Farm Financial Performance. Department of

Agricultural Economics, Purdue University Cooperative

Extension Service EC-712. (October 1999).

Ellinger, P. “Benchmarking Part 3: Profitability and Profitability

Components.” Ag Lender. Volume 8, Issue 7 (July 2004): 12-

13.

Financial Characteristics of Illinois Farms. The Center for

Farm and Rural Business Finance, University of Illinois at

Urbana-Champaign. (2003-2004).

Financial Guidelines for Agricultural Producers:

Recommendations of the Farm Financial Council (Revised).

(July 1997).

Lins, D. and Ellinger P. “Establishing Norms for Financial

Performance Measures,” Agri Finance. (January, 1992): 5-6.

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Table 1. Possible courses of action to improve profit performance1

1 Adapted from Jolly, Robert and Alan Vontalge. Financial Troubleshooting, Iowa State University Extension Publication, Pm-1618,

May, 1995

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Figure 1. Worksheet 1, Input information

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Figure 2. Worksheet 2, Financial performance measures

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Figure 3. Worksheet 3, Repayment capacity ratios and measures

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Figure 4. Worksheet 4, Assessing the effect of a change on rates of return early planting

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