Using the Standards with Producers and Lenders to Analyze Operations

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1 Using the Standards with Producers and Lenders to Analyze Operations Todd Doehring Centrec Consulting Group, LLC FFSC 2012 Conference -- 1

2 Agenda Background Producers Census data Decision support activities (budgeting/planning) Financial analysis/ratios Du Pont Financial Analysis Model Lenders Types of analysis Earned net worth change Du Pont Financial Analysis Model Acceptance of guidelines Departures from guidelines FFSC 2012 Conference -- 2

3 Background Develop and deliver both self-study and online training materials for ag lenders in the areas of financial and credit analysis, risk, loan structuring. Develop spreading software for analyzing the financial performance ag producers and supporting our training efforts. Provide management consulting (decision support services) for our ag production clients. Use both Managerial and Financial Guidelines. FFSC 2012 Conference -- 3

4 Total ~2.2M FFSC 2012 Conference -- 4

5 Total ~117K FFSC 2012 Conference -- 5

6 Total ~$300B FFSC 2012 Conference -- 6

7 Total ~$217B FFSC 2012 Conference -- 7

8 Avg ~$134K FFSC 2012 Conference -- 8

9 Avg ~$1.865M FFSC 2012 Conference -- 9

10 FFSC Financial/Managerial Guidelines Working with Producers FFSC 2012 Conference -- 10

11 Activities Transactions Coded by Segment, Account, & Prod Year Allocations & Adjustments Reports (Internal & External) Analysis & Modeling Planning & Budgeting Accounting System Decision Support FFSC 2012 Conference -- 11

12 Crop Budget Revenue Acres Yield Price Crop insurance guarantee Direct expenses Per bushel Per acre Indirect expenses Allocate via acres, revenue, or production, etc. Margin SG&A Taxes Financing Profit Withdrawals Acres Planned Planted Harvested Yield per acre Units (lbs, bu) bu Expenses Chemicals: Herbicide Cost, $/acre Allocation, %/month Chemicals: Insecticide Cost, $/acre Allocation, %/month Crop insurance Cost, $/acre Allocation, %/month Crop scouting Cost, $/acre Allocation, %/month Custom hire Cost, $/acre Allocation, %/month Drying Cost, $/bu Cost, $/acre 0.00 Allocation, %/month Indirect expenses General Crop Cost, $/acre Allocation, %/month Machinery Cost, $/acre Allocation, %/month FFSC 2012 Conference -- 12

13 Crop Production/Marketing Cycle Initial crop plans: pre-order inputs, potential forward contract, futures positions or options, if prices warrant action Crop insurance decision, 3/15 Acreage reporting date, 7/15 Coverage ends at harvest; Payment due 10/31 Crop insurance in effect from plant to harvest 1 Finalize crop plans Plant Harvest Sales of planned crop Sales of growing crop Sales at harvest 2 Sales of inventory 2 Purchases of inputs Sales Price Risk* Input Cost Risk* *Risk goes down as crops are sold and input cost locked not necessarily smooth. 1 Depending on crop insurance, prevented plantings covered 2 Reversal of hedging positions, if any FFSC 2012 Conference -- 13

14 Inc: Alpha County--Corn Enterprise Units 480 Acres RP 80% 139 APH, units/a $/Acre 1400 Revenue, $/Acre Net Income, $/Acre Units/Acre Coverage Yield Insured Premium Level Covered Revenue per Acre 50% % % % % % % % % #N/A Probability of yields 5% chance yield exceeds % chance yield exceeds % chance yield exceeds % chance yield exceeds % chance yield exceeds % chance yield exceeds % chance yield exceeds % chance yield exceeds % chance yield exceeds Per Acre Analysis Expected Insured Breakeven Yield, bu/acre Price, $/bu Other measures / ratios Revenue, $/acre Insured revenue / Crop insurance premium Crop insurance cost, $/acre Insured costs / Insured net income All other costs, $/acre % Crop insurance premium as % of total costs Net income, $/acre Benefit index (Insured net income / Crop ins. prem.) Crop insurance cost, $ 9,298 9,298 9, Value of payout if occuring at insured yield, $/acre Crop insurance cost, $/bu Payout index (Value of payout / Crop ins. prem.) Probability of achieving yield, % 50.0% 93.3% 99.8% Total production, bu 67,778 53,376 39,550 Insured production, bu 53,376 53,376 53,376 At-risk production, bu 14,402 - (13,826) FFSC 2012 Conference -- 14

15 Livestock Budget Revenue Head Weight Price Revenue Direct expenses Per lb Per head Indirect expense Usually allocate via head-days, revenue, or production Margin SG&A Taxes Financing Profit Withdrawals FFSC 2012 Conference -- 15

16 Livestock Production/Marketing Cycle Livestock Sales Livestock Pricing Opportunities Sales Price Risk Feed Pricing Options Livestock Expenses Feed Cost Risk Other Input Cost Risk FFSC 2012 Conference -- 16

17 12/31/2011 FFSC Ratios 2011 Liquidity 1 Current Ratio Working Capital $ - 3 Working Capital/Gross Revenues 0.0% Key Ratio Solvency 4 Debt/Asset Ratio, market 0.0% Key Ratio a Debt/Asset Ratio, market (excl def tax) 0.0% Key Ratio 4 b Debt/Asset Ratio, book 0.0% Key Ratio 5 Equity/Asset Ratio, market 0.0% a Equity/Asset Ratio, market (excl def tax) 0.0% 5 b Equity/Asset Ratio, book 0.0% 6 Debt/Equity Ratio, market 0.00 a Debt/Equity Ratio, market (excl def tax) b Debt/Equity Ratio, book 0.00 Profitability 7 Rate of return on assets, market 0.0% 7 b Rate of return on assets, book 0.0% Key Ratio 8 Rate of return on equity, market 0.0% 8 b Rate of return on equity, book 0.0% Key Ratio 9 Operating profit margin ratio 0.0% Key Ratio 10 Net Farm Income $ - 11 EBITDA $ - Financial Efficiency 12 Asset turnover ratio, market b Asset turnover ratio, book 0.00 Key Ratio 13 Operating Expense Ratio 0.0% Key Ratio 14 Depreciation Expense Ratio 0.0% Key Ratio 15 Interest Expense Ratio 0.0% Key Ratio 16 Net Income from Operations Ratio 0.0% Key Ratio Repayment Capacity 17 Capital Debt Repayment Capacity (CDRC) $ - 18 Capital Debt Repayment Margin (CDRM) $ - 19 Replacement Margin $ - 20 Term Debt & Capital Lease Coverage Ratio - Key Ratio 21 Replacement Margin Coverage Ratio - FFSC 2012 Conference -- 17

18 FFSC Profitability/Efficiency Ratios Du Pont Financial Analysis FFSC 2012 Conference -- 18

19 ROA is Comprised of Two Key Components Operating profit margin indicates earnings available to pay interest and income taxes Operating profit margin = Net farm income from operations + Interest expense Gross revenue Withdrawals as unpaid labor Asset turnover ratio indicates the dollar of GR being generated by each dollar of asset Asset turnover ratio = Gross revenue Average farm assets ROA is the product of these two measures ROA = Operating profit margin Asset turnover ratio FFSC 2012 Conference -- 19

20 ROA Percentages It is possible to achieve the same ROA with different levels of operating margin and asset turnover. How does agriculture compare to other industries? ROA Profit Margin Asset Turnover 10% % % 40.00% % 20.00% % 13.33% % 10.00% % 6.67% % 5.00% % 3.33% % 2.50% % 2.00% % 1.00% FFSC 2012 Conference -- 20

21 Du Pont Model (ROA) Return on average farm assets (ROA) Operating profit margin (OPM) Asset turnover ratio (ATR) EBIT Gross revenue Average farm assets, book FFSC 2012 Conference -- 21

22 Extending Du Pont to Consider ROE ROA and ROE are linked by the cost of liabilities and the overall leverage of the operation. Because some liabilities are interest bearing and some are not, the issue is not the interest rate on borrowed funds, but the average cost of liabilities. % of Liabilities Interest rate Weighted average interest rate Liability Balance Accounts payable 65, % 0.00% 0.00% Operating loan 135, % 6.00% 1.27% Accrued expenses 90, % 0.00% 0.00% Notes payable 350, % 7.00% 3.83% Total 640, % An easier way to calculate this is to divide interest expense for the year by average total liabilities. FFSC 2012 Conference -- 22

23 Modified Du Pont Model (ROE) Return on average farm equity (ROE) Return on average farm assets (ROA) + Spread between ROA and COL Average debt/ equity ratio Return on average farm assets (ROA) - Average cost of liabilities (COL) Operating profit margin (OPM) Asset turnover ratio (ATR) Average farm equity, book EBIT Gross revenue Average farm assets, book - Average farm liabilities FFSC 2012 Conference -- 23

24 Du Pont Model Inputs Every business decision will impact one of these three drivers: Operating profit margin (margin, earns) Asset turnover ratio (volume, turns) Financial structure (leverage, financing) Only seven* numbers are required: Gross revenues Operating expense* Depreciation expense* Interest expense Withdrawals for labor and management Average assets, book-basis Average liabilities, book-basis * Needed to compute net income from operations and allows for computation of efficiency ratios. FFSC 2012 Conference -- 24

25 FFSC 2012 Conference -- 25

26 Du Pont Model Comments The greater the positive spread between ROA and average cost of liabilities, the more leverage that can be handled by an operation. Fluctuations in ROA are multiplied by leverage in terms of their effect on ROE; the direction of the multiplier is determined by a positive or negative spread between ROA and the average cost of liabilities. If ROA is greater than ROE, deleveraging will increase ROE and reduce income and repayment sensitivities to a given change in revenue or expense. Book-basis analysis is most meaningful. FFSC 2012 Conference -- 26

27 Du Pont Model Caveats Assets, liabilities, and equity are averaged from the beginning and ending balance sheet. Thus, significant changes in the operations (either expansion or contraction) can lead to erratic results in these numbers. Withdrawals are used in both equations as a proxy for unpaid family labor (amounts different than the value of unpaid labor will distort the ratios). ROE measures are meaningless for highly leveraged operations with little or negative equity. Both measures are pre-tax. Use caution when using the Du Pont model with marketbasis values. FFSC 2012 Conference -- 27

28 Financial Efficiency Measures for Illinois Financial Efficiency Measures (%) by Type of Farm Average Grain Farms Operating Expenses Depreciation Interest NFI from Operations Hog Farms Operating Expenses Depreciation Interest NFI from Operations Dairy Farms Operating Expenses Depreciation Interest NFI from Operations Beef Farms Operating Expenses Depreciation Interest NFI from Operations Source: Illinois Farm Business Farm Management, FFSC 2012 Conference -- 28

29 FFSC Financial Guidelines Working with Lenders FFSC 2012 Conference -- 29

30 Analysis Types B/S Impact on Earnings Ability to Detect Errors None High High High Low Low Moderate High FFSC Focus FFSC 2012 Conference -- 30

31 Measures of Income Tax: Net profit (loss) from Schedule F Generally distorted for tax management Cash: Net cash income May be distorted by timing of events Earned net worth Proxy for accrual earnings Net income, accrual-adjusted True indicator of profitability FFSC 2012 Conference -- 31

32 Schedule F Items to Note FFSC 2012 Conference -- 32

33 About Earned Net Worth Change Useful when there is insufficient information to do a reconciled analysis No fiscal year-end balance sheets are available Before tax returns or cash income and expenses are available Process involves isolating changes in equity that are actually caused by earnings Not from market-based revaluation Not from gifts in or out Not from changes in net personal assets Not from inconsistencies in the balance sheets FFSC 2012 Conference -- 33

34 Earned Net Worth Change Process Beginning Balance Sheet Value Market +/ value net worth = change Market owner equity change Book owner equity change Earned net worth change Remove impact of personal assets Remove impact of valuation equity Remove impact of gifts, inheritances Net income after withdrawals Not Farm Not Realized Not Earned Ending Balance Sheet Value FFSC 2012 Conference -- 34

35 ENW Change Example For this example, assume Beginning net worth: 500,000 Ending net worth: 600,000 Machinery, land, and buildings were revalued as: Machinery and equipment Ending market value, 1/12/X2 325,000 -Purchases (75,000) +Depreciation 27,000 -Beginning market value, 11/7/X1 (275,000) =Revaluation/(Devaluation) 2,000 Land Ending market value, 1/12/X2 400,000 +Sales 25,000 -Beginning market value, 11/7/X1 (350,000) =Revaluation/(Devaluation) 75,000 Buildings and improvements Ending market value, 1/12/X2 130,000 +Depreciation 12,000 -Beginning market value, 11/7/X1 (150,000) =Revaluation/(Devaluation) (8,000) FFSC 2012 Conference -- 35

36 ENW Change Example, continued So, the ENW calculation is as follows: 600,000 Ending net worth 8,000 + Devaluation 77,000 - Revaluation 500,000 - Beginning net worth 31,000 = Earned net worth change Retained earnings increased by $31,000, so the farm actually earned more than this because the operator took withdrawals, (e.g., if withdrawals were $60,000, then the farm earned $91,000). 31,000 Earned net worth change 60,000 + Owner withdrawals 91,000 = Estimated net income FFSC 2012 Conference -- 36

37 Earned Net Worth Change Example EARNED NET WORTH CHANGE (Actual $) Green Valley Ranch ENW Chg* ENW Chg* ENW Chg* ENW Chg* ENW Chg* For Yrs w/* Centrec Case Study (c) /27/ /3/2007 2/1/2009 1/8/ /31/ Year Avg EARNED NET WORTH CHANGE CALCULATION Total net worth, end of period 4,809,830 5,338,223 5,565,645 5,519,721 5,765,772 Total net worth, beginning of period 4,260,503 4,809,830 5,338,223 5,565,645 5,519,721 Total change in net worth 549, , ,422 (45,924) 246, ,054 - Change in net personal assets (9,123) (7,850) (2,119) (8,647) 23,348 (878) - Change in valuation equity (513,564) (402,367) (196,575) 68,915 (204,248) (249,568) = Change in retained capital 26, ,176 28,728 14,344 65,151 50,608 = Earned net worth change (ENW) 26, ,176 28,728 14,344 65,151 50,608 + Withdrawals as unpaid labor 55,000 57,000 58,000 60,000 62,000 58,400 = Owner withdrawals, net 55,000 57,000 58,000 60,000 62,000 58,400 = Estimated net income (ENW + WD) 81, ,176 86,728 74, , ,008 Capital asset valuation summary Ending market value 5,010,907 5,353,533 5,539,466 5,451,110 5,575,369 - Purchases (83,538) (59,104) (78,342) (68,615) (9,020) (59,724) + Sales 24,998 46,167 14,716 4,455 5,594 19,186 -/+ Gain/loss on sales (2,824) 329 (3,396) (3,955) (5,094) (2,988) + Depreciation 70,169 72,349 77,664 87,556 88,509 79,249 - Beginning market value (4,506,148) (5,010,907) (5,353,533) (5,539,466) (5,451,110) = Total change in valuation equity 513, , ,575 (68,915) 204, ,568 FFSC 2012 Conference -- 37

38 FFSC Financial Guidelines Departures from Common Lender Practice FFSC 2012 Conference -- 38

39 Key Recommendations: Departures from Common Lender Practice Cost and Market of Capital Assets Balance Sheet Format Two Category Income Statement Format (Business only) Separation of Personal Assets and Liabilities Treatment of Withdrawals and Non-Farm Income on the Statement of Cash Flows and Income Statement Incorporation of Deferred Taxes Incorporation of Capital Leases Depreciation Book, Not % of Market or Tax FFSC 2012 Conference -- 39

40 Some Common Misconceptions Credit Analysis Myth: The FFSC Recommendations are meant as credit analysis recommendations. Fact: Development of an effective credit process requires evaluation of numerous factors beyond the scope of the FFSC Recommendations. FFSC 2012 Conference -- 40

41 Some Common Misconceptions GAAP Compliance Myth: FFSC Recommendations are meant as a substitute for or replacement of GAAP. Fact: FFSC Recommendations are based on the Conceptual Framework documents, and are largely consistent w/gaap. Accountant opinions based on FFSC Recommendations are and will continue to be qualified. FFSC 2012 Conference -- 41

42 Some Common Misconceptions Partial Adoption Myth: Partial adoption is not worthwhile. Fact: Many organizations have not adopted all of the FFSC Recommendations. Trend to total adoption continues to grow, partial adoption can provide significant benefits. FFSC 2012 Conference -- 42

43 Some Common Misconceptions Financial Statement Format Myth: Only the financial statement formats included in the Recommendations are acceptable. Fact: Financial statement formats included in the Recommendations are for illustrative purposes only the key is consistency with the methods themselves. FFSC 2012 Conference -- 43

44 FFSC Guidelines: Implications for Ag Lenders More Availability of CPA Statements More Consistency in Education and Software Faster Development of Integrated Production/ Financial Databases Greater Value of Internal Databases FFSC 2012 Conference -- 44

45 Acceptance of Guidelines In our training, we often take an informal poll about familiarity with FFSC and use of guidelines. Most lenders deploy a portion of the standards. Many credit departments understand and integrate many of the guidelines the exception being deferred tax (the only guideline recommendation that has zero compliance). It s not that lenders don t agree with or ignore the standards they have made sound business decisions and only move to full accrual-adjusted analysis when risk warrants (sufficient volume and size of operation). FFSC 2012 Conference -- 45

46 Acceptance of Guidelines, cont. FFSC was/is an educational effort, and overall level of discussion across producers and lenders has definitely increased. FBFM has been a full adopter (except deferred taxes) of the guidelines and their statements are high quality. They have a very significant presence in Illinois, provide good statements for producers, lenders, and numbers for research. FFSC 2012 Conference -- 46

47 Conclusions FFSC 2012 Conference -- 47

48 Conclusions Managerial accounting allows our clients to get to true cost of production numbers which allows for detailed analysis of the operation (or various segments). We have found that the Du Pont model is a good focal point for analysis. It bring together earnings (profit margin) and turnover (asset utilization) along with debt structure. It s then easy to scan operating efficiency. Guidelines can be (and are used for) but are not necessarily for credit analysis (financial analysis is one of many aspects). Lenders have made sound business decisions and only further analyze when risk warrants (sufficient volume and size of operation). FFSC 2012 Conference -- 48

49 Thank You! Todd Doehring 3 College Park Court Savoy, IL Phone: (217) FFSC 2012 Conference -- 49

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