Editor's note: The following article was first published in Iowa State University Extension and Outreach's Ag Decision Maker.
Do you know where your business stands financially? Completing year-end financial statements can help one evaluate a business, large or small, on the profitability and ability to cash flow through statement and ratio analysis.
Most farm families do a good job of keeping records of income and expenses for the purpose of filing income tax returns. Values from the tax return, however, may not accurately measure the economic performance of the farm. The numbers in your tax return are the key to various reports that can be used to gauge the health of your farm, business or personal finances. Let’s look at some of these tools.
A balance sheet is also called a net worth statement. It captures a snapshot of assets and liabilities on the given date it is constructed. Net worth (assets less liabilities) is the amount of capital retained in the business from profits or investment. Additionally, a net worth statement can provide insight to one’s ability to pay current and long term debts. Like profits, one should want their net worth to grow from year to year.
An income statement calculates profit by taking revenue less expenses. A majority of this information is available on a tax return; however, one must be sure to include actual depreciation and interest paid. A cash income statement can provide insight to how profitable a business is during a year’s time based on the net income calculated (accounting profit). Another measure of profit is economic profit, accounting profit less opportunity cost of investment and labor. Additionally, one can also calculate accrual net income, the cash income statement adjusted for inventory adjustments that results in a more accurate measure of profitability for the given time period. Profitability is important to measure from year to year to measure the feasibility of financial success.
A balance sheet and income statement should also be completed at of the end of December to provide a consistent time frame for comparison year to year.
Other financial statements
Additional financial statements should be prepared to get a complete picture of the financial health of a business. A cash flow statement is a look at the flow of cash in and out of a business during a period of time. A business may be profitable, but not able to cash flow or meet financial obligations during periods of year based on inflow of cash. Another statement is the statement of owner’s equity; this statement uses both the balance sheet and income statement and measures the growth in equity between time periods.
As you close out 2011 records, you should prepare year-end financial statements to evaluate the financial health of your operation. Various ratios can be calculated from these statements that can reveal areas you can work on in 2012 to be a more financially viable business. Key ratios that can be reviewed include current ratio, working capital, debt-to-asset, return on assets, net farm income ratio, and operating expense ratio. These ratios are important to measure against benchmark averages and over time to gauge change in one’s business.
Understanding the financial health of your farm or business is key to its success. Additional information on formulating financial statements and completing analysis can be found on Ag Decision Maker at www.extension.iastate.edu/agdm/wdfinancial.html, or at the Center for Farm Financial Management at www.cffm.umn.edu/publications/FarmMgtTopics.aspx.