The Four Parts of Every Business

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3 The Four Parts of Every Business Four Parts Concept Main Financial Reports Assets What is owned 1. Balance Sheet 2. Statements of Cash Flows Liabilities What is owed 1. Balance Sheet 2. Statements of Cash Flows Equity Operations Owner(s) portion of the business Production part of the business 1. Balance Sheet 2. Statement of Cash Flows 3. Changes in Owner Equity 1. Income Statement 2. Statement of Cash Flows 3

4 Assets Current Assets -Cash -Accounts Receivable -Inventories (e.g. crops) Non-current Assets -Breeding Livestock -Land -Buildings & Improvements -Machinery & Equipment -Investments Total Assets Liabilites Current Liabilities -Notes Payable -Accounts Payable -$ Due this YR on LT Debt Non-current Liabilities -Real Estate Debt Owners Equity -Stock -Retained Earnings Total Liabilities & OE 4

5 The Balance Sheet identifies and accounts for the financial status of the Assets, Liabilities and Equity (Net Worth) parts of the business. 5

6 Assets = Liabilities + Owners Equity Assets: something of value firm owns or uses. It can be sold to generate cash, or it can be used to produce other goods that in turn can be sold for cash in the future. Current assets: either cash now or will turn into cash within accounting period (liquid assets) Non-current assets: something firm owns or uses that will not turn into cash within accounting period. 6

7 Four Parts of the Business Concept and Example Accounts Liabilities Liabilities: obligation to pay debt Current liabilities: debt must be paid within next accounting period Non-current liabilities: debt where payment or repayment of obligation will be made after next accounting period 7

8 Liquidity measures the ability of the business to meet financial obligations as they come due without disrupting the normal operations of the business. Liquidity measures the ability to generate cash needed to pay obligations. Liquidity is generally measured over the next accounting period and is a short-run concept. Current ratio and Working capital 8

9 Current ratio = Current asset value Current liability value Current ratio = $117,500 $88,850 = 1.32 (market value) To have enough cash, the ratio needs to be above

10 Working capital = Current assets current liability Working capital = $117,500 $88,850 = $28,650 (surplus) (market value) Positive working capital is a good sign for leveraging (power of borrowing) the farm enterprise. 10

11 Solvency measures the liabilities of the business relative to the amount of owner equity invested in the business. It provides an indication of the ability to pay off all financial obligations or liabilities if all assets were sold. If assets are not greater than liabilities, the business is insolvent. Debt/asset ratio, Equity/asset ratio, and Debt/equity ratio 11

12 Debt/asset ratio = Total liabilities Total assets $400,000 Debt/asset ratio = = 0.40 $1,000,000 (market value) Total debt-to-asset ratios tend to be higher for larger farms and for farms that specialize in livestock feeding. Ratios of 30 to 40 percent are common among South Carolina farms. 12

13 Equity/asset ratio = Owner equity Total assets $600,000 Equity/asset ratio = = 0.60 $1,000,000 (market value) Greater than 40 percent is acceptable. If you add the debt-toasset ratio and the equity-to-asset ratio you must get 100%. 13

14 Debt/equity ratio = Total liabilities Owner equity $400,000 Debt/equity ratio = = 0.67 $600,000 (market value) This is a measurement of how much suppliers, lenders, and creditors have committed to the company versus what the shareholders have committed. For every $1 from Equity, another $0.67 is commited by the creditors. 14

15 Liquidity Current ratio 1.32 Working capital $28,650 Solvency: Debt/asset ratio 0.40 Equity/asset ratio 0.60 Debt/equity ratio

16 Two types of Balance Sheets are: 1. Cost Basis: lists asset values at their original cost, less amortization/depreciation, plus actual money spent for improvements to those assets. 2. Market Value Basis: the most probable price in cash or terms equivalent to cash, for which the appraised asset will sell in a competitive market. Most used in agriculture. 16

17 Accounts Payable: These are the debts that your business owes to suppliers. It is also called 'A/P' for short or 'Creditors'. Accounts Receivable: These are the outstanding debts that your customers owe to your business. It is also called 'A/R' for short or Debtors. Double Entry Accounting: In this method every transaction has two entries: a debit and a credit (also called a journal entry). Debits must always equal credits. Most if not all accounting software use double entry accounting. General Ledger: This is a collection of different types of accounts (balance sheet, income, expense) that are used to keep the accounting records of a business. A general ledger works with double entry accounting and journal entries for each transaction. Accrued Interest: Interest expenses that may be incurred in one year but not paid until the following year. Notes Payable: This is a note promising to pay a certain amount of money at a certain time (within 12 months). Deferred Tax: Income tax expenses that may be incurred in one year but not paid until the following year. Current Portion of Term Debt: A portion of the balance sheet that represents the total amount of long-term debt that must be paid within the next year. Retained Earnings: A portion of the balance sheet that shows the amount of net income that has accumulated in a farm or ranch business since it began. This is part of Equity that increases from a positive net profit from operations. 17

18 An Income Statement reports the profitability of Operations for a specific period of time, for example, January 1, 19XX through July 31, 19XX. This report provides management information about the Operations part of the business, which except for the profit or loss line in Equity, is not included in the Statement of Financial Condition. Similar to 1040 Schedule F (IRS). Fiscal year Example: July 1, 2010 to June 30, 2011 Calendar year Example: January 1, 2011 to December 31,

19 Operating Income and Expense accounts contain only the financial activity for the current year and do not accumulate from year to year. Asset purchase does not show here, only its depreciation. 19

20 Cash Basis Accounting recognizes revenue when actually received (cash) and expenses when actually paid. Accrual Basis Accounting recognizes revenue when produced (not received yet) and expenses when they are incurred (not paid). It provides the most accurate income statement for the farm business.

21 The Statement of Cash Flows shows the actual flow of cash (no accrual entries) through all four parts (Assets, Liability, Equity and Operations) of the business for a specified period. The Statement of Cash Flows also identifies if there has been adequate capacity (Cash) within the business to pay its debt in time. Principal payments must be made to avoid new borrowing.

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23 Cash Outflow and Cash Available (Cash Inflow minus Cash Outflow) 23

24 The Statement of Change to Owner Equity reports activity in the Equity part of the business Contributed Capital Retained Earnings Market Value Adjustments It quantifies the amount of change to owner equity for the current year and identifies where changes have occurred. General Ledger Equity account balances and account activity are used to prepare this report. 24

25 Depreciation, which is the allocation of the expense that reflects the using up of capital assets employed by the entity, is subject to a number of different calculation approaches. No depreciation method is perfect, and it is important to note that depreciation is a method of allocation, not of valuation. Any difference between the net book value (original cost or other basis less the total of depreciation charged) and the actual value of the asset is not recognized until the asset is sold, and then it is shown as a gain or loss on disposal. A perfect depreciation method would result in the net book value of the asset being exactly equal to the market value of the asset at any time during its useful life.

26 Straight line methods result in an equal amount being charged each period. Depreciation allows for the build-up of working capital to replace the asset at the inflated price. Straight Line: For example, if a tractor costing $50,000 was determined to have a seven-year useful life and an $8,000 salvage value at the end of the seven-year period, a straight line depreciation method would result in a depreciation charge on the tractor of $6,000 per year ([$50,000 minus $8,000 equals $42,000], divided by seven years).

27 The Modified Accelerated Cost Recovery System (MACRS) is a depreciation method that is used only for income tax, that results in more being charged in the early part of the asset s useful life. Salvage value is not taken into consideration. A determinable useful life, but not an unlimited life is broken down by categories. Land is not depreciable, but some improvements to land (e.g. drains) are depreciable.

28 Cash and loans make the bulk of the capital to operate a farm business. Cash: comes from retained earnings (profits), outside investors who seek above-average earnings, credit in the form of farm debt (borrowing). Loans: either cash, or in the form of assets (livestock, land, etc) and inputs (fertilizer, seed, etc.) Types of Loans: short-term operating loans for inputs; intermediate-term production capital for machinery, buildings and livestock; and long-term fixed capital for land and processing facilities. 28

29 Single Payment: Borrow $20,000 at 12% per year, a single payment (short-term: notes payable within one year) Interest = $20,000 x.12 x 1 = $2,400 Line of Credit: payment is made when farm income is received, and no fixed repayment schedule. Interest= $20,000 x 0.12 x 4/12 = $800 (4 months) Interest= $60,000 x 0.12 x 2/12 = $1,200 (2 months) Amortized Payments: debt where payment or repayment made in the form of installments. You pay interest and the principal on the same monthly or yearly installment. 29

30 Amortization Schedule AMORTIZATON SCHEDULE Amount of Loan 50,000 Annual Interest Rate 10.0% Term of Loan (in months) 10 Monthly Outstanding Month Payment Principal Interest Balance 50, $5, , , , , , , , , , , , , , , , , , , , , , , , , , , , , (0.00) Equal Principal Payment: same amount of principal due every payment. Equal Total Payment: same amount of total payment with a declining balance and declining interest: $50,000 at 10% 1 st Year = Principal $ st Year = Interest $4, nd Year = Principal $ nd Year = Interest $4, th Year = Principal $5, th Year = Interest $43.24

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32 An enterprise budget provides an estimate of potential revenue, expenses, and profit for a single enterprise Each type of crop or livestock is an enterprise The base unit for crops is usually one acre The base unit for livestock may be one head or some other convenient size 32

33 Item Value per acre Revenue 250 $5.50 per cwt $1, Variable Costs Seed $80.00 Fertilizer Chemicals Machinery expense Custom Spray 8.00 Harvesting and Hauling Labor % for 6 months Total variable cost $1, Income above variable cost $ Fixed Costs Machinery depreciation, interest, taxes, and insurance $62.00 Land charge Total fixed costs $ Total costs $1, Estimated Profit (return to management) $19.78 Fixed Costs 33

34 Revenue: all cash and noncash revenue from the crop Operating or variable expenses: all costs that would be incurred only if the crop is produced Ownership or fixed expenses: costs that must be paid even if no crop is produced Profit: represents a return to all resources that were not charged in the budget (usually management) 34

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36 The unit may be one head, one cow unit for cattle, one litter for swine, or 100 birds for poultry Several enterprise budgets can be constructed for different sizes of the same enterprise, such as 30 head, 50 head, and so on to reflect economies of size The time period is usually one year but may be longer in some cases 36

37 (1 cow unit = 1 cow, 0.04 bull, 0.9 calf, 0.12 replacement heifer) Item Unit Quantity Price Amount Revenue Cull cow (0.10 head) cwt $50.00 Heifer calves (0.33 head) cwt Steer calves (0.45 head) cwt Total revenue $ Operating expenses Hay ton Grain & supplement cwt Salt, minerals cwt Pasture maintenance acre Veterinary & health expense head Livestock facilities head Machinery & equipment head Breeding expenses head Labor hours Miscellaneous head Interest (on half of operating expenses) $ % Total operating expense $ Fixed: Ownership expenses Interest on breeding herd $ % Fixed: Livestock facilities Depreciation & interest head Fixed: Machinery & equipment Depreciation & interest head Others: Land charge acre Total ownership/fixed expenses $ Total expenses $ Profit (return to management) ($42.27) 37

38 An economic enterprise budget includes information on opportunity costs of labor, capital, land and perhaps management. The profit (or loss) is what remains after covering all expenses, including opportunity costs. A projected economic profit of zero means labor, land, and capital are earning exactly their opportunity costs. 38

39 Whole Farm Budget: A management tool that shows the physical and financial plan for the entire farm or ranch business for a specific period of time. Competitive Enterprises: When an increase in the level of production of one enterprise causes a reduction in the level of production of another enterprise. Break-even: The output required for revenue to equal the total of fixed and variable costs. Partial Farm Budget: A management tool that shows projected costs and net returns associated with some changes in the farm business. Depreciation: A fixed cost that accounts for the wear and tear of fixed assets. 39

40 Break-even yield = total cost output price $159 = = 63.6 bu $2.50 Price per bushel ($) Break-even yield (bu) Break-even yield is the minimum yield necessary to make the farm business feasible at different prices (Net Profit >= 0). 40

41 Break-even price = total cost expected yield $159 = = $4.42 (bu) 36 Yield (bu) Break-even price ($) Break-even price is the minimum price necessary to make the farm business feasible at different yields (Net Profit >= 0). 41

42 Additional Costs: costs that do not exist at current time but will be incurred if the change is made Reduced Revenue: revenue that is currently received but which will be lost or reduced if the change is made Additional Revenue: revenue to be received only if the alternative is adopted Reduced Costs: costs that are now incurred which would be eliminated if the change is made 42

43 Problem: Additional Costs: Additional Revenue: Reduced Revenue: Reduced Costs: A. Total additional costs B. Total additional revenue and reduced revenue $ and reduced costs $ $ Net Change in Profit (B-A) $ 43

44 PARTIAL BUDGET Problem: Purchase combine to replace custom hiring (1,000 acres wheat) Additional Costs: Fixed costs Depreciation $10,000 Interest 8,000 Taxes 100 Insurance 300 Variable costs Repairs 2,500 Fuel and oil 1,300 Labor 550 Reduced Revenue: None Additional Revenue: None Reduced Costs: Custom combining charge 1,000 $20 per acre $20,000 A. Total additional costs B. Total additional revenue and reduced revenue $22,750 with reduced costs $20,000 $22,750 Net Change in Profit (B-A) ($2,750) 44

45 Additional Costs: Additional Revenue: Fixed costs 5 cull cows $2,500 Interest on cows/bulls $2, steer calves Bull depreciation $.85 9,775 Taxes heifer calves 460 $.78 6,458 Variable costs Labor 600 Vet and health 500 Feed and hay 2,000 Hauling 300 Miscellaneous 200 Pasture fertilizer 1,500 Interest on variable costs 320 Reduced Revenue: PARTIAL BUDGET Problem: Add 50 beef cows and convert 100 acres from grain to forage Reduced Costs: Grain Productin Fertilizer 2,750 5,000 $3.00 $15,000 Seed 1,400 Chemicals 1,200 Labor 1,500 Machinery 1,000 Interest on variable costs 470 A. Total additional costs B. Total additional revenue and reduced revenue $23,220 with reduced costs $27,053 $23,220 Net Change in Profit (B-A) $3,833 45

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47 A cash flow budget is a summary of the projected cash inflows and outflows for a business over a period of time. The time period is usually a future accounting period and is divided into quarters or months. As a forward planning tool, its primary purpose is to estimate the amount and timing of future borrowing needs and the ability of the business to repay loans. 47

48 Time Period 1 Time Period 2 1 Beginning cash balance $1,000 $500 Cash inflow: 2 Farm product sales 2,000 12,000 3 Capital sales 0 5,000 4 Miscellaneous cash income Total cash inflow 3,000 18,000 Cash outflow: 6 Farm operating expenses 3,500 1,800 7 Capital purchases 10, Miscellaneous expenses Total cash outflow 14,000 2, Cash balance -11,000 16,000 (line 5 - line 9) 11 Borrowed funds needed 11, Loan repayments 0 11,700 (principal and interest) 13 Ending cash balance 500 4,300 (line 10 + line 11 - line 12) 14 Debt outstanding $11,500 $0 48

49 Projected Cash Flows: Includes Projected cash income, cash expenses, and debt payments. Cash problems: When expenses are more than income you should use savings, delay expenses, move sales, or borrow money. A Term-Debt Coverage Ratio: Measures if there is sufficient cash to cover all current term (farm and non-farm) debt payments. The ratio (1.60:1) indicates the farm business has $1.60 for each $1 of debt payment. Capital Replacement and Term Debt Repayment Margin: Amount of cash remaining after all expenses, family living, income taxes, and scheduled debt payments have been made. 49

50 Term Debt Coverage Ratio Net farm income from operations + Total non-farm income + Depreciation/amortization expense + Interest on term debt + Interest on capital leases - Total income tax expense - Withdrawals for unpaid labor and management (family living)) / (Annual scheduled principal and interest payments on term debt + Annual scheduled principal and interest payments on capital leases) * Interpretation: The ratio provides a measure of the ability of the borrower to cover all term debt and capital lease payments. The greater the ratio, over 1:1, the greater the margin to cover the payments. A strategy to improve the term-debt coverage ratio is to reduce farm business operating expenses. 50

51 Capital Replacement and Term Debt Repayment Margin Net farm income from operations + Total non-farm income * + Depreciation/amortization expense - Total income tax expense - Withdrawals for unpaid labor and management (family living) = Capital replacement and term debt repayment capacity (loss carryover) - Payment on unpaid operating debt from a prior period - Principal payments on current portions of term debt - Principal payments on current portions of capital leases - Total annual payments on personal liabilities (if not included in withdrawals) * = Capital replacement and term debt repayment margin * This measure enables borrowers and lenders to evaluate the ability of the farm proprietor to generate funds necessary to repay debts with maturity dates longer than one year and to replace capital assets. 51

52 1. Plan borrowing and debt repayment 2. Suggest ways to minimize borrowing 3. Combine business and personal financial affairs into one complete plan 4. Help establish realistic line of credit 5. Plan purchases to obtain discounts 6. Aid tax planning 7. Find imbalances between current and noncurrent debt 52

53 Interest Payment Due in August Principal Interest March (5 months of Interest = 5/12) borrowing $36,800 x 9% x 5/12 of a year = $1,380 April borrowing $16,400 x 9% x 4/12 of a year = $492 May borrowing $6,900 x 9% x 3/12 of a year = $155 June borrowing $7,300 x 9% x 2/12 of a year = $110 Total $67,400 $2,137 53

54 Year Cash inflow: Increase in crop income $16,800 $16,800 $16,800 $16,800 $16,800 Cash Outflow Additional crop expenses 3,600 3,600 3,600 3,600 3,600 Irrigation expenses 3,000 3,000 3,000 3,000 3,000 Principal payments 14,000 14,000 14, Interest payments 5,040 3,360 1, Total cash outflow 25,640 23,960 22,280 6,600 6,600 Net cash flow -8,840-7,160-5,480 10,200 10,200 54

55 Cash generated to pay operating loans as a percentage of total cash inflows: Operating Loans Total Cash Inflow x 100 Cash generated to pay operating loans as a percentage of total operating expenses: Loan Interest and Principal Total Operating Expenses x 100 Interest paid as a percentage of cash farm operating receipts: Loan Interest Total Cash Inflow x 100 Ending net cash value as a percentage of total cash inflows: Ending Cash Available Total Cash Inflow x 100 Term loan interest as a percentage of total expenses: Loan Interest Total Expenses x 100 Operating sales total as a percentage of total cash inflows: Total Operating Sales Total Cash Inflow x

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57 Agribusiness firms possess majority of power in most marketing channels Two types of marketing Commodity handling: moving commodities through marketing channel to consumers (e.g., eggs, milk) Product marketing: transforming raw commodities into differentiated products to be sold in the market. Most firms engage in both. 57

58 Transportation Storage Processing Procurement and merchandising Standardization and market intelligence Financing and risk bearing 58

59 Marketing mix: attention to a set of activities including product design promotion, channel organization, and pricing. These activities designated Four Ps : Product Promotion Place Price 59

60 Law of supply: Sellers will offer more at higher prices than at lower prices, other factors holding constant Law of demand: Quantity of a good purchased will increase as its price is reduced 60

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62 Price discovery: process of buyers and sellers arriving at prices for a commodity when market conditions do not permit either group to set prices. All market participants are individually price takers or price negotiaters. Usually associated with fairly equal numbers of buyers and sellers. 62

63 A marketplace for persons interested in buying or selling commodities based on today s information and the perception of where prices will be in the future. Grew out of: The need for certain parties to guard against undesired price movements over time The desire by certain parties to assume the risk of price movements in return for profit 63

64 Chicago Board of Trade Chicago Mercantile Exchange New York Board of Trade Kansas City Board of Trade Minneapolis Grain Exchange Also Tokyo, China, Brazil 64

65 You think Price will increase in the future You will be long (or a buyer) in the market. Since the price is expected to increase, you would sell a commodity for profit. You will long the market. The options term call is synonymous with being a buyer. You think Price will decrease in the future You will be short (or a seller) in the market. Since the price is expected to decrease, you would buy a commodity later for profit. You will short the market. The options term buy is synonymous with being a seller. 65

66 Futures contract: A regulated market mechanism in which sellers and buyers agree to sell/buy a commodity at an explicit price and date in the future. Arbitrage: Process whereby a commodity is simultaneously bought and sold in two different markets to take advantage of a price discrepancy. Hedging: Process whereby a person who owns a commodity uses the futures markets to transfer the price risk or to establish a price. 66

67 Put option: Gives an individual the right but not the obligation to sell a futures contract at a specified price during a specific time period Call option: Gives an individual the right but not the obligation to buy a futures contract at a specified price during a specific time period Strike price: The price at which the futures market can be entered under an option 67

68 Strike Price Specific price owner has right to buy or sell Premium Cost of buying an option at a particular strike price In the Money Put futures is below strike price In the Money Call futures is above strike price Intrinsic Value Difference between the underlying futures and an in the money put or call Time Value Difference between options premium and intrinsic value 68

69 Option contracts offer a range of strike prices so purchasers can choose the level at which they may eventually want to take a futures position Terms describe where the strike price is relative to the underlying futures contract price: In-the-money At-the-money Out-of-the-money 69

70 Intrinsic value: value relative to the underlying futures price Time value: reflects time between the option premium quote and contract expiration Option premium: value that a hedger or speculator pays for the right to take a futures position later 70

71 Difference between a local cash price and the relevant futures contract price for a specific time period Basis = Cash price Futures price Positive basis: Cash market is above futures market. Basis is narrowing or strengthning. Negative basis: Cash market is below futures market. Basis is widening or weakening. 71

72 Futures Market Sell $7.00 Futures and Price Falls to $6.50 Gain of $.50 in Futures Loss $.50 in Cash Net selling price $7.00 Options Market: Put Buy $7.00 put for $.15 premium and price falls to $6.50. Offset put for $.60 premium Loss of $.50 in cash, gain of $.45 on options Net selling price $

73 Futures Market Sell $7.00 Futures and Price Rises to $7.50 Gain of $.50 in Cash Loss of $.50 in Futures Net selling price $7.00 Options Market: Put Buy $7.00 put for $.15 premium and price rises to $7.50. Let put expire Gain of $.50 in cash market Less $.15 premium Net selling price $

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87 A tax is a financial charge upon an individual by a state or functional equivalent such that failure to pay is punishable by law. Expenditures for military, the enforcement of law and public order, protection of property, economic infrastructure (roads, legal tender, enforcement of contracts, etc.), public works, social engineering, and the operation of government itself. Governments also use taxes to fund welfare and public services. These services can include education systems, health care systems, pensions for the elderly, unemployment benefits, and public transportation. Energy, water and waste management systems are also common public utilities. 87

88 Sales tax: a tax charged at the point of purchase for certain goods and services. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale. The tax amount is usually calculated by applying a percentage rate to the taxable price of a sale. Usually assessed by individual states, but some counties may raise tax rates. Income tax: tax levied on the income of individuals or business. Property tax: a tax that an owner is required to pay on the value of the property being taxed. Controlled by local government at the municipal or county level. The assessment is made up of two components the improvement or building value, and the land or site value. 88

89 Federal Insurance Contributions Act (FICA) tax - payroll (or employment) tax imposed by the federal government on both employees and employers to fund Social Security and Medicare: federal programs that provide benefits for retirees, the disabled, and children of deceased workers. Considered a regressive tax (a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases) on income. Social Security tax: tax collected to fund Social Security program. This contribution or tax is 6.2% of an employees' income paid by the employer, and 6.2% paid by the employee (12.4% total). Has a maximum cap limit amount. Medicare tax: tax collected to fund the Medicare program. Health insurance program for the elderly and disabled. 89

90 Good Income Tax Management should help maximize the aftertax income. Proper income tax management should result in level income from year to year. Real estate held at the death of the owner gets a new basis of fair market value. Commodity credit (CCC) grain transactions can be considered loan or sales income. The report given to each employee and the IRS on wages paid is W2. Farm income and expenses are reported to the IRS on Schedule F. The sale of the cull cows will be reported on Form

91 Self-employed individuals can deduct 100% of health insurance premiums. The maximum deduction for Section 179 expensing in 2012 and 2013 is $500,000. A net operating loss of a farm or ranch can be carried back to 5 years. In a low-income year, a farmer should: (1) Collect money due from custom work done, (2) Use straight line depreciation, (3) Delay all possible expenditures, or (4) Take the option of reporting sealed grain as income. In a high-income year, a farmer should: (1) Borrow money at bank to pay outstanding debt, (2) Delay livestock or crop sales, (3) Buy feed and other supplies for future use, (4) Pay wages to family members, (5) Buy needed equipment for increased depreciation, or (6) Use 179 expensing rule. 91

92 Sale of raised products Sale of items purchased for resale Government Program Payments Patronage Refunds Crop Insurance proceeds Custom Hire Money received from the sale of raised beef cows (assets) is a Capital Gain, NOT Farm Income. 92

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106 Depreciation is the annual deduction taken on capital assets. It can be deducted as an expense to reduce Taxes. It spreads out the cost of capital assets over their useful life. Assets with a useful life of more than one year, may not be deducted as an expense in the year of purchase. Part of the cost of the asset will be deducted in each year of that asset s productive life until the value is zero. 106

107 Useful life of more than one year Used in the business Must be purchased 107

108 General Depreciation System (GDS) Modified Accelerated Cost Recovery System (MACRS) recovers cost quicker GDS & MACRS can use Straight Line or Declining Balance options 108

109 3 Year Property Breeding Swine 5 Year Property Breeding Sheep, Cattle Trucks, Computers 7 Year Property Machinery, Equipment, Fence 10 Year Property Single purpose lvstk/hort struct. 20 Year Property Farm Buildings 27.5 Year Property Residential Property 31.5 Year Property Office buildings, motels, stores 109

110 Purchase price of asset divided by the years of service Ex: $140,000 combine depreciated over 7 years = $20,000 per year 110

111 Gives largest depreciation deductions at the beginning, then smaller each year More accurately represents the wear and tear of the asset 111

112 Allows you to take up to $17,500 of the purchase price of an asset the first year, then depreciate the rest Ex: $140,000 combine, Sec. 179 of $17,500 first year = new basis of $122,500 Depreciate $122,500 over 7 years = $17,500 per year Why use Section 179? 112

113 The IRS does NOT allow you to take a full year s depreciation for the first year that an asset is placed in service May use the month, quarter, or year the asset is placed into service Mid-Month, Mid-Quarter, Mid-Year 113

114 Mid-month convention etc. only affects the first and last year of a depreciation schedule Ex: If you purchase a $140,000 combine in August Depreciated over 7 years = $20,000 per year Year #1 dep. = 5/12 $20,000 Year #2-7 dep. = $20,000 Year #8 dep. = 7/12 of $20,

115 Item purchased: Tractor Date purchased: May 5 Cost: $70,000 Years of Service: 7 Straight Line Depreciation Convention: Mid-Month 115

116 Year 1 = $6,667 Year 2 = $10,000 Year 3 = $10,000 Year 4 = $10,000 Year 5 = $10,000 Year 6 = $10,000 Year 7 = $10,000 Year 8 = $3,

117 Item purchased: Tractor Date purchased: Dec 5 Cost: $70,000 Years of Service: 7 Straight Line Depreciation Section 179 Deduction: $17,000 Convention: Mid-Quarter 117

118 Year 1 = $ 1,893 Year 2 = $ 7,571 Year 3 = $ 7,571 Year 4 = $ 7,571 Year 5 = $ 7,571 Year 6 = $ 7,571 Year 7 = $ 7,571 Year 8 = $ 5,

119 Item purchased: 10 Heifers Date purchased: Sept. 10 Cost: $800 Years of Service: 5 Straight Line Depreciation Convention: Mid-Month 119

120 Year 1 = $ 400 Year 2 = $ 1,600 Year 3 = $ 1,600 Year 4 = $ 1,600 Year 5 = $

121 Sell marketable grain/livestock Off Farm Income Postpone expenditures until beginning of next year Pay bills beginning of Of next year Don t use Section

122 Postpone sales until next year Use deferred sales contracts Buy machinery, supplies etc before end of year Use Section 179 Make advanced purchases Pay wages to family members 122

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124 A dollar today is preferred to a dollar in the future: 1. The dollar could be invested to earn interest. 2. If dollar is spent on consumption, we d prefer to get the enjoyment now. 3. Risk is also a factor as unforeseen circumstances could prevent us from getting the dollar. 4. Inflation may diminish the value of the dollar over time. 124

125 Present Value (PV) : the number of dollars available or invested at the current time or the current value of some amount to be received in the future Future Value (FV) : the amount to be received at some future time or the amount a present value will be worth at some future date when invested at a given interest rate 125

126 Payment (PMT) : number of dollars to be paid or received in a time period Interest Rate ( i ) : also called the discount rate the interest rate used to find present and future values, often equal to opportunity cost of capital Time Periods ( n ) : the number of time periods used to compute present and future values Annuity : a term used to describe a series of periodic payments 126

127 Future Value of $1,000 at 8% Interest Rate FV = PV ( 1 + i ) n FV = $1,000 ( ) 3 FV = $1, Compound Factor

128 Future Value of $2,000 at 5% Interest Rate FV = PV ( 1 + i ) n FV = $2,000 ( ) 3 FV = $2, Compound Factor

129 Present Value of $1,000 at 8% Interest Rate PV = PV = FV (1 + i ) n $1000 = $ ( ) 3 Discount Factor

130 Present Value of $2,000 at 5% Interest Rate PV = PV = FV (1 + i ) n $2000 = $ ( ) 3 Discount Factor

131 Annual Payment of PV of $1,000 at 8% Interest Rate PMT = PV PMT = $1000 i 1 ( 1 + i ) -n 0.08 = $ ( ) -3 Annual Payment Factor

132 Annual Payment of PV of $2,000 at 5% Interest Rate PMT = PV PMT = $2000 i 1 ( 1 + i ) -n 0.05 = $ ( ) -3 Annual Payment Factor

133 Searching for profitable investments is an important managerial function that needs systematic and thorough attention. Four methods are used for investment analysis: Simple rate-of-return (SSR = Profits / Investment) SSR = $2,000 / $10,000 = 20% Payback period (PB = Investment / Cash Flows) PB = $10,000 / $2,000 = 5 years Net present value (NPV) Internal rate-of-return (IRR) Only the NPV and IRR methods directly account for the time value of money. 13 3

134 Net Present Value (NPV) is the sum of the present values of each year s net cash flow minus the initial investment. Bob $1000 received every year, after a $2000 investment at 8% per year. NPV = P 1 + P P n C (1 + i ) 1 (1 + i ) 2 (1 + i ) n.. NPV = $ $ $ $2000 ( ) 1 ( ) 2 ( ) 3 NPV = $ $ $ $2000 (1.08) (1.1664) (1.2597) NPV = $ = $ Discount Factors 134

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136 Risk management terminology: Uncertainty: Where the probability of an event occurring cannot be empirically determined. Risk: Unexpected circumstances where the probability of an event occurring can be empirically determined. Insurance: Device used by firms to protect against uncertainties and possible financial loss. Insurance Premiums: The payment to an insurance company by a policyholder to purchase and maintain an insurance policy. Risk Management: The act of managing or controlling exposures to risk in order to meet preset objectives or risk exposure guidelines. 136

137 The types of farm business risks have been classified into five categories: production, marketing,financial, legal and human resource. There are various ways that each of the risk categories can be managed: Production Risk: Purchase crop insurance, install irrigation system. Financial Risk: Rent machinery rather than purchase machinery, Shift from a variable interest rate loan to a fixed interest, Increase cash reserves, Reduce the amount of borrowed money. Legal Risk: Purchase liability insurance, develop a limited liability company (LLC). Marketing Risk: Forward contract, Futures contract or Options contract. Human Resource Risk: Purchase health insurance, Provide training opportunities to employees. 137

138 The increase in input prices is an indication of production risks. Price of seed goes up by 10%. Seed price: $30/bag + 10% = $33/bag) Cost of Production ($10/acre) goes up by 3%. Additional seed price $3/bag $10 x 100 = 3% Break-even price to cover total operating expenses: 0 = Price x Q Total Operating Cost P = Total Operating Cost Q P = $ bu./acre = $0.1 per bu. Insurance payment at 75% of revenue. Insurance Floor = Revenue x 0.75 (payment is triggered) Insurance Floor = ($0.1 per bu. x 100 bu/acre) * 0.75 = $7.50/acre Revenue less than $7.50 per acre would trigger insurance. 138

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140 Historically, the term family living withdrawals has been widely used in connection with farming operations that were organized other than as a corporation. These withdrawals are typically shown in the statement of owner equity and not on the income statement. However, to distinguish when these withdrawals are for family living versus other legitimate withdrawals of capital from the business seems to be a time-consuming task of limited usefulness for purposes of analysis. Therefore, the FFSC recommends that the term family living withdrawals no longer be utilized. 140

141 Operations Expense accounts record expenses incurred by the business during the production of revenue. Fertilizer, seed, chemicals, rent, supplies, repairs, veterinary and utilities are examples of expense accounts. Post a debit to the General Ledger when expenses (+) increase and a credit when they (-) decrease. 141

142 1. Sole Proprietorship: No special legal procedures (you and your business are the same), permits, or licenses. Owner(s), family, can hire management and employees, lease buildings and land, own assets, and growth as much as they want. Owners are fully liable for any legal difficulties, debts, assume all risks (including personal assets, business continuity), and receive all profits and losses (Form 1040, Schedule C). 142

143 2. Partnership: Simple to establish and does not require the same amount of record keeping as a corporation. Income is taxed only once. Each partner pays federal, state, and local taxes on income. The owners are fully liable for any all risks (a bank may request any assets for defaulting). Limited partnership can be oral or written (depending on each state) and does not allow for managerial activities, but it does limit debt/profit to its share. Easy to dissolve. 143

144 3. Corporations: not so simple to establish and does require record keeping as a corporation (Limited Liability Company, LLC; C or S- Corporation). Each partner is considered a separate entity. The owners are not fully liable for any all risks and they control how much profit to share. Not easy to dissolve. An LLC with only a single shareholder, a so-called single-member LLC, is taxed as a sole proprietor. 144

145 Why an S-Corporations: profits and losses are not taxed at the corporate/business level like they would be if the corporation remained as a C Corporation. C-Corporations: these are taxable entities, which means profit/dividends at the corporation level is taxed and shareholders are also taxed upon dividends/income received, double taxation. 145

146 Real estate can be held in several different ways: Tenancy in common: Provides owners with undivided interest with no rights of survivorship but with rights to convey, mortgage and otherwise care for as is available through fee simple ownership. Fee simple: Gives the owner the unrestricted right to sell, mortgage or dispose of real estate. Co-ownership: Property is owned by two or more owners with undivided interests. Life estate: Entitles a person to receive income from or use of property for his/her life only. Joint tenancy: Provides owners with undivided interests and with rights of survivorship. Tenancy by entirety: Provides owners with undivided interest and with rights of survivorship but does not allow for conveyance without consent of the other party involved. 146

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148 Asset turnover ratio: gross revenue market value of total farm assets Operating expense ratio: total operating expenses Depreciation expense ratio: total depreciation expense Interest expense ratio: total farm interest expense gross revenue gross revenue gross revenue 148

149 Net farm income from operations ratio: net farm income gross revenue Livestock production per $100 feed fed Feed cost per 100 pounds of gain Crop value per acre Gross revenue per person Machinery cost per crop acre 149

150 Financial Health: it measures the ability to borrow and repay its commitments. Solvency: the firm s ability to repay all debts with its assets. The increase in liabilities as a proportion of assets (or equity) makes the firm less solvent. Liquidity: less liquid (it has less cash on hand) and that has more of its money tied up in its receivables. This lack of cash has lowered the firm s ability to pay its bills on time as reflected in the rise in accounts payable. 150

151 The Debt-to-Asset ratio is calculated by dividing total liabilities by total assets. This ratio indicates how much the operation is leveraged. Generally, the higher the ratio, the higher the risk of insolvency. Debt-to-Equity is calculated by dividing total liabilities by total equity. This ratio indicates how the farm is financed. Lower ratios are preferred. A higher ratio indicates that there is greater long term risk and less flexibility. 151

152 Working capital is calculated as current assets minus current liabilities. This ratio indicates the amount of capital that is available for current operations. Current ratio is calculated as current assets divided by current liabilities. This ratio reflects the ability to pay expenses, as they occur, with current assets. A ratio of greater than one is preferable, but aim for greater than two. The acid test ratio tells you whether you could pay your bills if you had to do so on short notice since it uses just cash as it numerator. 152

153 153

154 Return on Investment (ROI) measures the return on capital invested in the farm business (shows good management skills) and is calculated by dividing the farm s return to assets (return to investment on both debt and equity) by the average farm assets for the year. Return on equity (ROE) measures how much a company earns within a specific period in relation to the amount the owners have invested in it. It is calculated by dividing the farm s return on equity (return to equity without the management contribution to profits) by the average equity for the year. If the ROE is higher than the company's ROI, it may be a sign that management is using leverage to increase profits and profit margins. 154

155 Asset Turnover Ratio measures the how efficiently capital invested in farm assets is been used. It measures ability to use assets to generate sales. It is calculated by dividing the farm s sales by the average farm assets for the year. Inventory Turnover Ratio measures the number of times the inventory is used and replaced each year. It is calculated by dividing the farm s CGOS by the ending inventory level. Higher ratios are preferable since products can deteriorate as they sit in a warehouse or on the field. 155

156 Economic Efficiency measures how efficiently managers are able to generate more production in terms of operating profits with the use of fewer resources in terms of operating costs. It is calculated by dividing the farm s operating profits by its operating cost for the year. Labor Productivity measures the efficiency of utilizing labor to generate more production in terms of operating profits. It is calculated by dividing the farm s operating profits by labor cost for the year. Higher ratios are preferable since additional products can be sold by means of productive operating practices. 156

157 net farm income from operations plus total nonfarm income plus depreciation expense plus interest paid on term debt and capital leases minus withdrawals for family living and personal income taxes 157

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159 159

160 160

161 Equilibrium price is the price at which the quantity demanded by consumers and the quantity that firms are willing to supply of a good or service are the same. 161

162 When the own price of a product changes, the outcome is a movement along the demand curve and when any other determinants (prices of substitute products, prices of complementary products, population, advertising, wage changes, etc) of demand change, there will be a Shift of the Demand Curve. 162

163 A Shift in the Supply Curve occurs when firms will tend to supply more or less of their products at any given price due to changes of the conditions of supply, such as cost of production, prices of other products, and changes in profits. 163

164 Elasticity is a general concept that quantify the percentage relationship between two variables. Elasticity determines the percentage change in one variable relative to a percent change in another variable. Coefficient of Elasticity = Percentage change in A. Types of elasticity: Percentage change in B Elasticity of (quantity) Demand with respect to price. Elasticity of (quantity) Supply with respect to price. Elasticity of investment with respect to interest rate. Elasticity of tax payments with respect to income. 164

165 The Price Elasticity of Demand PE(D) for a particular product may differ at different prices. For example, from $9 to $10 and from $10 to $11. Elastic Demand occurs when 1 percent change in price causes a change in quantity demanded greater than 1 percent. These products are said to be Price Elastic (E d > 1). Inelastic Demand occurs when 1 percent change in price causes a change in quantity demanded less than 1 percent. These products are said to be Price Inelastic ( 0 < E d < 1). Unitary Elastic Demand occurs when 1 percent change in price causes the same percentage change in quantity demanded. These products are said to be Unit Elastic (E d = 1). 165

166 166

167 The Price Elasticity of Supply PE(S) for a particular product is computed by dividing the percent change in quantity supplied by the percent change in price. Elastic Supply occurs when 1 percent change in price causes a change in quantity supplied greater than 1 percent. (E s > 1). Inelastic Supply occurs when 1 percent change in price causes a change in quantity supplied less than 1 percent. ( 0 < E s < 1). Unitary Elastic Supply occurs when 1 percent change in price causes the same percentage change in quantity supplied. (E s = 1). 167

168 Production is the process through which inputs are combined and transformed into outputs. Specific quantities of inputs are needed to produce any given service or good. For example: a loaf of bread requires certain amounts of water, flour, and yeast, kneading and patting, as well as an oven and gas or electricity. The Production Function is a mathematical expression which relates the quantity of all inputs to the quantity of outputs, assuming that managers employ all inputs efficiently. Q = F (I1, I2, I3,,In) 168

169 Units Produced Q The Units Produced will decline because of other limited resources such as land, machines, buildings. (Law of Diminishing Returns) L Units of Labor 169

170 Marginal Physical Product (MPP) is the additional output that can be produced by hiring or using one more unit of a specific input, holding all other inputs. MPP = Change in Total Product. Change in Variable Input However, at a certain point (maximum), it starts to decline to a point which another unit of input (labor) causes 0 increase in output. (Law of Diminishing Returns) The Law of Diminishing Returns states that when additional units of a variable input are added to fixed inputs, after a certain point, the marginal product of the variable input declines. 170

171 MPP,APP Increasing Marginal Returns (<A): output increases at an increasing rate. Decreasing Marginal Returns (A-C): output increases at a decreasing rate. Negative Marginal Returns (>C): output decreases. TPP A B C TPP Stage 1 Stage 2 Stage 3 Labor MPP APP Labor 171

172 Average Physical Product (APP) is the average amount produced by each unit of a variable factor of production. APP = Total Units Produced (TPP) _ Total Units of Variable Input (Q) MPP APP MP above AP A MPP= APP when APP is max MP below APP Stage 1 Stage 2 MPP APP 172

173 Construct a line or XY (scatter) chart showing the Q(B), TPP, MPP and APP from the data below. Fixed quantity A Q(A) = 40. Use the variable quantity data Q(B) as the x-axis. 173

174 Is it rational to produce when MPP is in the range of Q(B) from 0 to 25? What happens next (>25)? No. Increasing returns will not persist. Diminishing marginal returns will follow and then negative returns. What should you do about the stage of production for input levels of 40-45? Stage 2. TPP increases in a decreasing rate. Good management skills required!!!!! 174

175 Homogeneous (identical) products: i.e. the presence of perfect substitutes. No firm with a cost advantage: i.e. all firms have identical cost curves. A very large number of suppliers: thus no single producer by varying its output can perceptibly affect the total market output and hence the market price. Free entry into and exit from the industry: ensuring that competition is sustained over time. No transport and distribution costs to distort competition. Suppliers and consumers who are fully informed about profits, prices and the characteristics of products in the market. 175

176 The perfect competitive firm is a price taker. Any increase or decrease in its output will have no effect on the price of its product. If it raises its price, it sells nothing. If it lowers its price, it can sell no more than if it charges the market price. Marginal Revenue equals Average Revenue and equals Price; i.e. MR =AR =P. Profits are maximized where short-run marginal cost equates to marginal revenue (and average revenue or price). MC =MR 176

177 Unit Profit = AR ATC Profit maximization occurs when the MC = MR, and the amount of profit is the difference between Average Revenue and Average Total Cost. Revenue Profit P MC ATC Cost Q MR D=AR Quantity 177

178 Pure Monopoly: An industry with a single firm that produces a product for which there are no close substitutes and in which significant barriers to entry prevent other firms from entering the industry to compete for profits. Barriers to entry: Something that prevents new firms from entering and competing in imperfectly competitive industries: Government franchises: electric, gas, telephone firms. Patents: exclusive production of a product. Economies of Scale: large facilities. Ownership of Scarce Input: diamond producing business. In a monopoly, the firm is the industry. It faces a downward demand curve because the firm has enough information to predict how households will react to different prices. Profits are maximized where short-run marginal cost equates to marginal revenue (MR = MC). A Natural Monopoly is a firm in which the most efficient scale is very large. The single firm is producing nearly the entire amount demanded 178

179 Monopolistic Competition: An industry with a large number of firms, none of which can influence market price by virtue of size alone. Firms can differentiate their products and firms can enter and exit such an industry with ease. The restaurant business in the U.S.: although many restaurants fail, small ones can compete and survive because there are no economies of scale in the restaurant business. Product Differentiation: A strategy that firms pursue to achieve market power. Accomplished by producing products that have distinct positive identities in consumer s minds. In the short-run, a monopolistically competitive firm is like a monopoly and earn monopoly profits since it is the only producer of its unique product, but similar. Example: Cheerios, Oreo cookies. In the long-run, the firm loses its monopoly power and market share due to the entry of competitors whose products are equally differentiated and better priced. Profits are maximized where short-run marginal cost equates to marginal revenue (MR = MC). 179

180 Characteristics Perfect Competition Market Structure Monopolistic Competition Oligopoly Number of firms Very large number Many Few Barriers to entry None Low High Market power (control over price Type of product None Some Substantial Standardized Differentiate d Standardized or differentiated 180

181 Characteristics Perfect Competition Market Structure Duopoly Monopoly Number of firms Very large number Two One Barriers to entry None High High Market power (control over price Type of product None Substantial Substantial Standardized Standardized or differentiated Unique 181

182 Jobes, Steward, Casey and Purcell (2004). Farm and Ranch Business Management (5thedition). Deere &Company, John Deere Publishing, East Moline, Illinois Kay, Edwards and Duffy. Farm Management. McGraw-Hill Book Co., New York, NY. (6th edition, 2008) CDE NCQ, National FFA Core Catalog, Indianapolis, IN. (Published annually following the CDE.) Good source for examples of enterprise budgets and financial statements used in the CDE. Boehlje and Eidman (1984). Farm Management. John Wiley and Sons, New York, NY. Bowers, Love and Kletke (1994). Machinery Replacement Strategies. Deere &Company, John Deere Publishing, East Moline, Illinois 1244.Deere &Company. Dicks, Michael (1998). Agricultural Policy and How it Affects You, Deere &Company, John Deere Publishing, East Moline, Illinois Oltmans, Klinefleter, and Frey (2001) Agricultural Financial Reporting and Analysis. Doane Agricultural Services, St. Louis, MO. Purcell, Wayne D. (1995). Marketing Agricultural Commodities. Deere & Company, John Deere Publishing, East Moline, Illinois Wilson, Purcell, Burton, and Wahlberg (1994). Managing Livestock Production. Deere & Company, John Deere Publishing, East Moline, Illinois Wilson, Purcell, Burton, and Wahlberg (1994). Managing Agricultural Commodities.Deere & Company, John Deere Publishing, East Moline, Illinois AgriSolutions Inc. Ferreira, Wilder (2012). Clemson University Cooperative Extension Service. 18 2

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