MANAGING an agribusiness requires a good understanding

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1 Understanding Financial Statements MANAGING an agribusiness requires a good understanding of financial matters. Knowing when to buy new assets, sell old assets, borrow money, invest in the business, or buy a new business requires the ability to understand financial statements. What can they tell us? How are they used as tools to assess the financial health of a business? Objective: Identify the purposes of three common financial statements and explain how to develop the statements. Key Terms: accrual accounting method balance sheet cash accounting method cash-flow statement current ratio debt-to-asset ratio debt-to-equity ratio liquidity profit-and-loss statement profitability return-on-assets ratio return-on-equity ratio solvency working capital Financial Statements in Business Management Financial management is important to the success of a business. With an understanding of where you are, where you have been, and where you are going financially, you can make management decisions that maximize the profitability of the business. Page 1 AgEdLibrary.com

2 The Big Three financial statements most often used in business are the balance sheet (also called the net worth statement), the profit-and-loss statement (also called the income statement), and the cash-flow statement. These three statements, along with the financial ratios that can be calculated from them, provide information to managers and other interested persons about the ability of a business to pay off debts, operate effectively, and return a profit. Business owners must be consistent in the way they track their financial activity. There are two methods of accounting that businesses use to document their income and expenses. The cash accounting method records income and expenses when the money is received or payment is made. For example, if Weber Florists bought and paid for greenhouse plants in September, sold them in December, and received payment from its customers in January, the expense would be recorded in September and the income would be recorded in January. The cash method is very simple to use and understand but may be misleading. If Weber Florists uses January 1 through December 31 as its tax year, the business would show expenses for this transaction in one year, with no income from the transaction to offset those expenses. Similarly, records for the next tax year would show income with no offsetting expenses in that tax year for this particular transaction. The accrual accounting method records income and expenses when a sale is made or an expense is incurred regardless of when the money is received or payment is made. Using accrual accounting in our Weber Florists example, the expense would be recorded in September, and the income would be recorded in December even though the money itself was not received until January. Once a method of accounting is chosen, sticking with that method is important. Frequently switching methods or following a method inconsistently can create an inaccurate financial picture of the business and may result in tax consequences. THE PURPOSE OF FINANCIAL STATEMENTS The purpose of financial statements is to determine the financial standing of a business and to measure three main objectives: profitability, liquidity, and solvency. Profitability is the ability of a business to make a profit. After all the revenue is in and all the expenses are paid, is there a profit? Liquidity is the ability of a business to pay current obligations without disrupting normal operations. It is the ability to pay regular bills without having to sell off assets needed to operate the business. In short, being liquid means having enough cash to pay the bills. Solvency is the ability of a business to pay all its debts if the business were liquidated, or sold out. A solvent business must have more assets than it has debt. Financial statements can measure these objectives by showing the revenue a business is generating (profit-and-loss statement), the amount of cash it has available to pay current obligations (cash-flow statement), and the net worth of the business (balance sheet). With some fairly simply calculations, financial ratios can be computed that allow a business to compare its Page 2 AgEdLibrary.com

3 financial situation with that of the average business in its industry or with its own performance in previous years. Cash-Flow Statement A cash-flow statement shows all sources of cash for the year, as well as all uses of cash. Sources of cash may include products or services sold, cash on hand or balances of checking accounts, equipment sold, money borrowed, and any miscellaneous sources of cash. Uses of cash may include operating expenses, purchase of assets, principal payments on loans, and any other expenses paid for by the business. The cash-flow statement shows where the money went for a business. It can demonstrate the need for borrowing money and the ability to repay the lending institution. Balance Sheet A balance sheet, also known as a net worth statement, identifies all assets and liabilities of a business. The balance sheet is really a checkup on the financial standing of the business. Balance sheets are prepared annually. They show how financial progress is being made over previous years. As liabilities get paid off and a business owns a larger percentage of the assets, net worth should increase. Precision Lawn Care Balance Sheet December 31, 20 * Assets (owned or have value) Current Assets (converted to cash easily, can be used without disrupting business operations) Cash $1,200 Checking Account Balance 3,500 Accounts Receivable (payments due the business) 300 Total Current Assets $5,000 Noncurrent Assets (needed to run the business on an ongoing basis) Truck & Trailer $21,500 Lawnmowers 12,500 Blowers, Trimmers & Other Equipment 2,200 Total Noncurrent Assets 36,200 Total Assets $41,200 Page 3 AgEdLibrary.com

4 Liabilities (owed) Current Liabilities (owed this year) This Year s Portion of Equipment Loan $900 Accounts Payable (payments due suppliers) 200 Total Current Liabilities $1,100 Noncurrent Liabilities (owed after this year) Remaining Equipment Loan (mowers, truck) $10,500 Total Noncurrent Liabilities 10,500 Total Liabilities 11,600 Net Worth (also called Owner Equity) 29,600 Total Liabilities and Net Worth $41,200 *The purpose of the balance sheet is to organize everything owned and owed by the business at a specific time. The balance sheet should be done each year at the same time to identify changes in net worth. Both assets and liabilities can be identified as either current or noncurrent. Current assets are readily available to meet cash needs within one year s time. They may include cash, checking accounts, accounts receivable (money owed the company by clients), and inventory ready for sale. Current liabilities are debts owed within the next year. They may include accounts payable, such as bills owed to suppliers, and loan balances due within a year s time. Noncurrent assets and liabilities are those items that will remain on the company ledger longer than one year. Noncurrent assets may be machinery that will be used within a business for several years and other assets that, if sold, would interrupt the ability to operate the business. Noncurrent liabilities are those that will be paid more than a year into the future. Profit-and-Loss Statement A profit-and-loss statement (also known as an income or operating statement) shows all a company s revenue and expenses for a specific period, usually a year. Revenue includes all money coming into the company. Expenses are calculated as variable or fixed. Profit-and-loss statements are different from year to year depending on the revenue and expenses involved. Page 4 AgEdLibrary.com

5 Precision Lawn Care Profit-and-Loss Statement for Year Ending December 31, 20 * Revenue Lawn Services $92,500 Other Cash Income 500 Gross Income $93,000 Expenses Variable Cash Expenses Hired Labor $28,500 Gasoline, Fuel & Oil 7,500 Repair & Maintenance 2,500 Advertising 500 Grass Seed, Fertilizer & Herbicide** 3,500 Miscellaneous Cash Expenses 300 Total Variable Cash Expenses $42,800 Fixed Cash Expenses Depreciation of Equipment $3,200 Insurance 3,000 Interest on Debt 800 Total Fixed Cash Expenses 7,000 Total Expenses 49,800 Net Income (Gross Income Minus Total Expenses) $43,200 *The profit-and-loss statement, also referred to as the income or operating statement, shows the earnings of a business for a period, usually one year. It shows all revenue and all expenses and calculates net income. **Includes any year-to-year adjustments to inventory. CALCULATING FINANCIAL RATIOS There are several ways to measure the financial situation of an agribusiness. These tools study the profitability, liquidity, and solvency of the business. Page 5 AgEdLibrary.com

6 Measures of Profitability Profit is extremely important to a business. Without profit, a business will cease to operate once its money is gone! Two ratios are particularly valuable in measuring the profitability of a business. They are the return-on-assets ratio and the return-on-equity ratio. The return-on-assets ratio assesses the rate of return on the assets used in a business. An asset is anything of value the owner has invested in. To calculate the return-on-assets ratio, a profit-and-loss statement and a balance sheet are needed. Use the sample statements of Precision Lawn Care included in this E-unit. The owner of Precision Lawn Care has a net income of $43,200. The owner does not pay himself anything but figures his wages to be $30,000. The balance sheet for the business lists total assets of $41,200. Net Income: $43,200 minus Value of Unpaid Labor: $30,000 Net Income less Value of Unpaid Labor: $13,200 divided by Total Assets: $41,200 = 0.32 Return-on-assets ratio: 0.32:1 The lawn-service business returns $0.32 for every $1.00 in assets. The higher the ratio, the more profitable the business. Owners prefer to have few assets that generate a lot of dollars. Each type of business will be different for the type of return-on-assets ratio it has. Servicebased businesses without many tangible assets have much higher ratios because instead of having physical assets, they perform services. Equity is the bottom line on a balance sheet. Equity is the value of all assets after all liabilities have been subtracted. The return-on-equity ratio assesses the rate of return on the equity of a business. Again using our example of Precision Lawn Care, the return-on-equity ratio is calculated as follows: Net Income: $43,200 minus Value of Unpaid Labor: $30,000 Net Income less Value of Unpaid Labor: $13,200 divided by Equity (Net Worth): $29,600 = 0.45 Return-on-equity ratio: 0.45:1 For a comparison of profitability, both types of ratios can be compared with those of similar businesses or with those of the same business in past years. Page 6 AgEdLibrary.com

7 Measures of Liquidity Liquidity is the ability of a business to meet expenses or debt without interrupting normal business operations. It is essentially the ability to pay the bills without having to sell assets to do so. Working capital and current ratio are the two measures of liquidity used in agribusinesses. Working capital is calculated from the balance sheet by subtracting current liabilities from current assets. Since liquidity is a measure of being able to pay debts immediately, only assets and liabilities that will be realized within the current year are used. Using the Precision Lawn Care example, the current assets were $5,000, while the current liabilities were $1,100. Thus, the working capital is $3,900. Current Assets: $5,000 minus Current Liabilities: $1,100 Working Capital: $3,900 The higher the value, the greater the liquidity. If the number were negative, the business would not be liquid enough to meet obligations. Current ratio is the proportion the current assets are of the current liabilities. This ratio shows whether current assets could cover current liabilities if the business were liquidated. Current Assets: $5,000 divided by Current Liabilities: $1,100 Current Ratio: 4.55:1 A ratio over 1:1 is considered liquid. If the ratio is less than that, the business is at risk of short-term cash-flow problems. Measures of Solvency Solvency is the ability of a business to pay its debts if all its assets were liquidated. It is very important when applying for loans or other credit. Two measures of solvency are debt-to-asset ratio and debt-to-equity ratio. Debt-to-asset ratio assesses the proportion of what is owed against what is owned. It is calculated by dividing total liabilities by total assets. In the case of Precision Lawn Care: Total Liabilities: $11,600 divided by Total Assets: $41,200 Debt-to-asset ratio: 0.28:1 In this instance, the lower the ratio, the lower the debt. A high ratio would indicate to a lender that the business may have trouble paying back the debt. Page 7 AgEdLibrary.com

8 Debt-to-equity ratio compares debt to equity (net worth) instead of assets. Again, a lower number is preferred, as it shows fewer debts in relation to the equity in the business. Using our example: Total Liabilities: $11,600 divided by Total Equity (Net Worth): $29,600 Debt-to-equity ratio: 0.39:1 Both ratios for solvency are used to identify the ability of the business to repay debt. Summary: Financial statements and ratios are tools that help agribusiness managers measure profitability, liquidity, and solvency. Using these tools allows managers to compare their business performance with that of past years and with that of competitive businesses. These statements and ratios are also important in seeking loans and credit. Checking Your Knowledge: 1. Name two tools that can measure profitability. How are they calculated? 2. Name two tools that can measure liquidity. How are they calculated? 3. Name two tools that can measure solvency. How are they calculated? Expanding Your Knowledge: An agribusiness has a net income of $63,000. The owners do not get paid salaries but calculate the value of their unpaid labor at $40,000. Current assets of the business are $8,500, and current liabilities are $8,700. Total assets are $52,000, and total liabilities are $48,000. Perform all financial analysis ratios on this business. Web Links: StudyFinance.com NetMBA Page 8 AgEdLibrary.com