# Business Analysis: Which Financial Tools Should I Use? John F. Smith, Ph.D. Department of Animal Science and Industry, Kansas State University

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8 statement with historical data to measure the actual observed returns associated with a particular management intervention. However, often insufficient data exist with regards to both the number of observations (operations and/or years) and information about the characteristics of the different operations (e.g., facility type, static vs. expanding herd size, milking frequency, etc.). In this case, a partial budget analysis based on sound assumptions about expected impacts is often the best indicator as to the expected returns of a particular management intervention. This type of analysis simply examines the impact a change in the operation has on net returns in a three step process. The first step is to identify the benefits of the intervention. Second is identification of the costs associated with the intervention. Finally, we need to compare the benefits (gains) made in the first step to the costs (losses) identified in the second step. Figure 2 shows a schematic of what a partial budgeting analysis entails. To construct a partial budget, four values need to be identified: (1) increased revenue, (2) decreased costs, (3) increased costs, and (4) decreased revenue. It is important to note that not all four of these values will always be relevant and in some cases some of them cannot be quantified. Intervention Benefits Intervention Costs Increased revenue + Decreased costs Decreased revenue + Increased costs (3) (1) (2) (4) = Total benefit (B) = Total costs (C) Total benefit (B) - Total cost (C) = Profitability of Intervention Figure 2. Partial Budget Analysis Approach. It can be seen that by identifying the four factors identified in figure 2 the profitability of a particular management intervention can be calculated. A positive economic return points us in the direction of a good decision, while a negative outcome tells us that moving forward with the decision will be detrimental to overall business performance. In addition to calculating the profitability as benefits less costs (as depicted in the figure), a benefit-cost ratio can also be calculated (i.e., B / C). This ratio simply indicates the dollars of return generated for every dollar of cost. Once the partial budget has been constructed, it is often useful to do a breakeven analysis and/or a sensitivity analysis around some of the projected values to determine the impact they have on the profitability. Tables 7 and 8 are examples of using a partial budget to analyze the profitability of adding sprinklers and fans (i.e., a cooling system) in a free stall barn (Table 7) and using bst (Table 8). It is important to note that this same type of analysis could be done for almost any management decision made on the farm, e.g., 2X vs. 3X milking, synchronized reproduction programs, etc. However, because the partial budget analysis relies upon projections, it is important to remember that this type of analysis is only as good as the assumptions that go into the budget. As the complexity of the intervention being considered increases, the number of assumptions required also increases which may lead you to having less confidence in your expected value. This is the reason it is often useful to do the sensitivity analysis i.e., we recognize that some of our assumptions may be incorrect. Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 114

9 While profitable decisions ultimately contribute to improvements in balance sheets, income statements and cash flow statements, accurately assessing the profitability of individual decisions or the performance of individual enterprises can t be done solely with these reports. Partial budgeting gives us the required process to accurately assess those changes in income and expenses that are specifically associated with a particular management decision, without the problem of having the profitability of that decision clouded by other activities on the dairy that are irrelevant to the question at hand. Thus, the partial budget is a very powerful tool for analyzing different interventions management might be considering. Weaknesses of the partial budget are that it requires projections (not particularly a serious issue) and the fact that some income or cost impacts are overlooked (potentially a serious issue). Another weakness of the partial budget is it only shows the marginal impact on the business and there are times you will want to know what this does to the bottom line (e.g., the breakeven milk price in Tables 7 and 8) is only somewhat useful information for a manager the total breakeven for the dairy would likely be more meaningful). Net Present Value Net present value (NPV) analysis is a means of taking into account the fact that a time value of money exists (i.e., a dollar tomorrow is worth less than a dollar today). Generally a NPV analysis is nothing more than a partial budget (i.e., changes in income and costs) that takes into account the timing of the income and cost changes. There is no question that a properly done NPV that also takes into account taxes is the best type of analysis to use, however, the increased complexity of this method is often not warranted. For example, the data in Table 7 could be analyzed in a NPV framework because the costs of the fans represent a multi-year investment and thus the time value of money is somewhat relevant. However, given the magnitude of the investment, the increased complexity of discounting future income streams is not that critical and thus the simpler approach is appropriate (time value of money has somewhat been accounted for by using an amortization factor to proxy depreciation and interest costs of fans). Because NPV analysis likely is not needed to answer many of the questions dairy managers face, no example is provided here. If readers are interested in finding out additional information as to how to do a NPV analysis, they are encouraged to contact the authors. Enterprise/whole-farm budget An enterprise or whole-farm budget is similar to the partial budget except that as its name implies it is for the entire operation. This tool is very useful for looking at alternative scenarios with regards to facilities, milking frequency, or any other management intervention. For a dairy operation that also has a cropping enterprise, it is suggested that the crop income and costs be examined separately and thus we are referring to a dairy enterprise budget. For dairy operations that do not have other enterprises, the enterprise and whole-farm budget are the same thing. The advantage of the enterprise budget is that all factors have been accounted for and thus it could be argued that it is more difficult to overlook some impacts (a potential weakness of the partial budget). Thus, an enterprise budget subsumes a partial budget, i.e., anything you can look at in a partial budgeting framework can be duplicated in an enterprise budgeting framework. The difference being that many income and cost categories might not change across the scenarios being analyzed. A weakness of the enterprise budget is that, like the partial budget, it relies upon projections. However, as previously stated, this is not a serious issue for those producers that have good historical data to use in making projections. Additionally, by conducting a sensitivity analysis, the enterprise budget can be very useful for examining and quantifying the potential risk associated with a particular scenario or management intervention. Tables 9 and 10 are examples of whole-farm budgets reflecting the expected costs and returns of a 2,400 head lactating cow dairy at two levels of production for freestall barns and drylots, respectively. The Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 115

11 References Dhuyvetter, K.C., J.F. Smith, M. Brouk, and J.P. Harner, III. 2004a. Dairy Enterprise 2,400 Lactating Cows. Kansas State Univ. Coop. Ext. Serv. Bull. MF Available at Dhuyvetter, K.C., M. Brouk, J.F. Smith and J.P. Harner, III. 2004b. Dairy Enterprise 2,400 Lactating Cows (Drylot). Kansas State Univ. Coop. Ext. Serv. Bull. MF Available at Langemeier, M.R. 2004a. Balance Sheet A Financial Management Tool. Kansas State Univ. Coop. Ext. Serv. Bull. MF-291. Available at Langemeier, M.R. 2004b. Income Statement A Financial Management Tool. Kansas State Univ. Coop. Ext. Serv. Bull. MF-294. Available at Langemeier, M.R. 2004c. Cash Flow Projection for Operating Loan Determination. Kansas State Univ. Coop. Ext. Serv. Bull. MF-275. Available at Langemeier, M.R. 2004d. An Integrated Financial Management Package. Kansas State Univ. Coop. Ext. Serv. Bull. MF-905. Available at Langemeier, M.R. 2004e. Financial Ratios Used infinancial Management. Kansas State Univ. Coop. Ext. Serv. Bull. MF-270. Available at Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 117

12 Table 1. Balance Sheet for Dairy Farms in Kansas Farm Management Association ASSETS: 1/1/ /31/2003 Change Cash (1) 28,200 26,499-1,701 Marketable Securities (2) Accounts Receivable (3) 3,937 3, Fertilizer and Supplies (4) 7,148 7, Investment in Growing Crops (5) Crops Held for Sale and Feed (6) 70,120 80,503 10,383 Market Livestock (7) 3,431 2, TOTAL CURRENT ASSETS (8) 112, ,548 7,712 (Add Lines 1 through 7) Breeding Livestock (9) 199, , Machinery and Equipment (10) 209, ,148 4,342 Buildings (11) 80,288 75,674-4,614 Investments in Cooperatives (12) 51,468 50, Land (13) 495, ,094 18,169 TOTAL NONCURRENT ASSETS (14) 1,036,512 1,053,016 16,504 (Add Lines 9 through 13) TOTAL ASSETS (15) 1,149,348 1,173,564 24,216 (Add Lines 8 and 14) LIABILITIES AND OWNER EQUITY: Accounts Payable (16) Taxes Payable (17) Accrued Expenses (18) 2,725 2, Current Portion: Deferred Taxes (19) Notes Due Within One Year (20) 87,180 73,069-14,111 Current Portion of Term Debt (21) Accrued Interest (22) TOTAL CURRENT LIABILITIES (23) 89,905 75,520-14,385 (Add Lines 16 through 22) Noncurrent Portion: Deferred Taxes (24) Noncurrent Portion: Notes Payable (25) 234, ,034 18,816 Noncurrent Portion: Real Estate Debt (26) TOTAL NONCURRENT LIABILITIES (27) 234, ,034 18,816 (Add Lines 24 through 26) TOTAL LIABILITIES (28) 324, ,554 4,431 (Add Lines 23 and 27) OWNER EQUITY (29) 825, ,010 19,785 (Subtract Line 28 from Line 15) TOTAL LIABILITIES AND OWNER EQUITY (30) 1,149,348 1,173,564 24,216 (Add Lines 28 and 29) Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 118

13 Table 2. Balance Sheets for Dairy Farms in Kansas Farm Management Association ASSETS: 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 Cash 26,019 36,609 35,289 28,200 26,499 Marketable Securities Accounts Receivable 6,732 2,898 3,789 3,937 3,453 Fertilizer and Supplies 3,927 4,967 6,931 7,148 7,532 Investment in Growing Crops Crops Held for Sale and Feed 74,360 71,422 75,465 70,119 80,503 Market Livestock 1,027 1,360 9,699 3,431 2,561 TOTAL CURRENT ASSETS 112, , , , ,549 Breeding Livestock 187, , , , ,577 Machinery and Equipment 197, , , , ,148 Buildings 77,198 74,634 80,940 80,288 75,674 Investments in Cooperatives 43,668 41,748 44,808 51,468 50,523 Land 461, , , , ,094 TOTAL NONCURRENT ASSETS 967, ,371 1,024,860 1,036,511 1,053,016 TOTAL ASSETS 1,079,157 1,092,626 1,156,032 1,149,346 1,173,565 Accounts Payable Taxes Payable Accrued Expenses 1,266 1,337 1,359 2,725 2,451 Current Portion: Deferred Taxes Notes Due Within One Year 65,549 75,227 81,827 87,180 73,069 Current Portion of Term Debt Accrued Interest TOTAL CURRENT LIABILITIES 66,815 76,564 83,185 89,904 75,520 Noncurrent Portion: Deferred Taxes Noncurrent Portion: Notes Payable 194, , , , ,034 Noncurrent Portion: Real Estate Debt TOTAL NONCURRENT LIABILITIES 194, , , , ,034 TOTAL LIABILITIES 261, , , , ,553 OWNER EQUITY 817, , , , ,012 TOTAL LIABILITIES AND OWNER EQUITY 1,079,157 1,092,626 1,156,032 1,149,346 1,173,565 Net worth change, \$ 32,305-2,173 38,838-29,114 19,788 Net worth change (ROE), % 4.11% -0.27% 4.76% -3.41% 2.40% Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 119

14 Figure 1. Assets, Liability, and Equity of Dairy Farms in Kansas Farm Management Association \$1,400,000 \$1,200,000 Equity Liabilities \$1,000,000 \$800,000 \$600,000 \$400,000 \$200,000 \$ Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 120

15 Table Income Statement for Dairy Farms in Kansas Farm Management Association Farm Business Receipts: Amount Crop Cash Sales (1A) 56,317 Ending Crop Inventory (1B) 80,503 Beginning Crop Inventory (1C) 70,120 Accrual Gross Revenue from Crops (1A+1B-1C) (1) 66,700 Livestock and Milk Cash Sales (2A) 351,545 Ending Livestock Inventory (2B) 201,138 Beginning Livestock Inventory (2C) 202,456 Accrual Gross Revenue from Livestock and Milk (2A+2B-2C) (2) 350,227 Gain/Loss on Sale of Breeding Livestock (3) 0 Government Payments (4) 40,799 Crop Insurance Proceeds (5) 7,150 Other Farm Income (6) 15,068 GROSS REVENUE (Add Lines 1 through 6) (7) 479,944 - Livestock Purchases (8) 34,994 - Cost of Purchased Feed/Grain (9) 104,067 VALUE OF FARM PRODUCTION (Line 7 - Line 8 - Line 9) (10) 340,883 Farm Business Expenses: Labor Hired (11) 33,786 Repairs (12) 29,158 Seed (13) 12,240 Fertilizer (14) 19,720 Machine Hire (15) 7,737 Veterinarian Expense (16) 12,234 Marketing (17) 10,102 Fuel and Utilities (18) 23,949 Property Tax (19) 6,564 General Farm Insurance (20) 10,170 Cash Rent (21) 12,622 Herbicide and Insecticide (22) 11,256 Miscellaneous (23) 42,093 TOTAL CASH OPERATING EXPENSES (Add lines 11 through 23) (24) 231,631 + Expense Inventory Adjustment (25) Depreciation (26) 31,324 TOTAL OPERATING EXPENSES (Line 24 + Line 25 + Line 26) (27) 262,297 + Interest (28) 20,764 TOTAL EXPENSES (Line 27 + Line 28) (29) 283,061 NET FARM INCOME FROM OPERATIONS (Line 10 - Line 29) (30) 57,822 + Gain/Loss on Sale of Capital Assets (31) 199 NET FARM INCOME (Line 30 + Line 31) (32) 58,021 Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 121

16 Table Cash Flow Statement for Dairy Farms in Kansas Farm Management Association FARM CASH INFLOW Amount Crops and Livestock Grains (including crop insurance proceeds) (1) 60,201 Hay and Forage (2) 3,266 Dairy (3) 345,950 Other Livestock (4) 5,595 Government Payments (5) 40,799 Miscellaneous Income (6) 15,552 Capital Asset Sales (7) 0 Total (Add lines 1 through 7) (8) 471,363 FARM CASH OUTFLOW Feed (9) 104,067 Hired Labor (10) 33,786 Repairs (11) 29,158 Seed (12) 12,240 Fertilizer (13) 19,720 Machine Hire (14) 7,737 Veterinarian Expense (15) 12,234 Marketing (16) 10,102 Fuel and Utilities (17) 23,949 Property Tax (18) 6,564 General Farm Insurance (19) 10,170 Cash Rent (20) 12,622 Herbicide and Insecticide (21) 11,256 Miscellaneous Expense (22) 42,093 Interest (23) 20,764 Dairy Purchases (24) 32,454 Other Livestock Purchases (25) 2,540 Capital Asset Purchases (26) 53,035 Total (Add Lines 11 through 26) (27) 444,491 NET FARM CASH FLOW (Line 9 - Line 28) (28) 26,872 NON-FARM CASH FLOW Outside Equity Capital / Non-Farm Income (29) 23,951 Capital Withdrawals (30) -52,888 Income and Self-Employment Taxes (31) -5,496 Total (Add Lines 29 through 31) (32) -34,433 NET CASH FLOW (Line 28 + Line 32) (33) -7,561 Change in Cash Balance (Ending - Beginning) (34) -1,701 Change in Accounts Receivable (Ending - Beginning) (35) -484 Change in Investment in Coops (Ending - Beginning) (36) -945 Change in Total Loans (Ending - Beginning) (37) 4,431 Unaccounted for Funds (Line 33 - Lines 34 through 37) (38) 0 Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 122

17 Table Sources and Uses of Funds Statement of Dairy Farms in KFMA SOURCES OF FUNDS: Beginning Cash (1) 28,200 Cash Farm Receipts (2) 471,363 Decrease in Accounts Receivable (3) 484 Decrease in Investment in Cooperatives (4) 945 Capital Asset Sales (5) 0 Increase in Total Liabilities (6) 4,431 Outside Equity Capital (7) 12,296 Net Non-Farm Cash Income (8) 11,655 Total Sources of Funds (Add Lines 1 through 8) (9) 529,374 USES OF FUNDS: Farm Cash Operating Expenses (10) 391,456 Increase in Accounts Receivable (11) 0 Increase in Investment in Cooperatives (12) 0 Capital Asset Purchases (13) 53,035 Decrease in Total Liabilities (14) 0 Equity Capital Withdrawals (15) 0 Family Living Withdrawals (16) 52,888 Income and Self-Employment Taxes (17) 5,496 Ending Cash (18) 26,499 Total Uses of Funds (Add Lines 10 through 18) (19) 529,374 UNACCOUNTED FOR FUNDS: (Line 9 - Line 10) (20) 0 Table 6. Financial Ratios for Dairy Farms in Kansas Farm Management Association Liquidity 1/1/ /31/2003 Current Ratio Working Capital \$22,931 \$45,028 Solvency Debt/Asset Ratio Profitability 2003 Operating Profit Margin Ratio Rate of Return on Farm Assets Rate of Return on Farm Equity Financial Efficiency Asset Turnover Ratio Net Farm Income Ratio Operating Expense Ratio Depreciation Expense Ratio Interest Expense Ratio Total Expense Ratio Adjusted Total Expense Ratio Economic Total Expense Ratio Repayment Capacity Income Available for Capital Replacement and Term Debt Replacement \$42,417 Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 123

18 Table 7. Partial Budget Analysis for Adding Fans and Sprinklers to a Dairy Intervention Benefits: (1) Increased Revenue Increased milk 10 lb/day x 85 days x \$12/cwt \$ per cow (2) Decreased Costs None \$ 0.00 Total Benefits (B) \$ Intervention Costs: (3) Decreased Revenue None \$ 0.00 (4) Increased Costs Fans/sprinklers 1 \$85/cow x \$ Electricity \$10.65/kW (demand) \$0.06/kWh (energy) \$ 8.98 Water 1,360 gallons x \$1.60/1000 gallons \$ 2.18 Feed 4 lb/day x 85 days x \$0.07/lb \$ Total Costs (C) \$ per cow Profitability of Intervention Benefits minus Costs \$ \$56.25 \$ per cow Benefit-Cost (B/C) ratio \$ / \$ Breakeven Analysis: Breakeven milk price 2 \$56.25 / (10 lb x 85 days) x 100 \$ 6.62 per cwt Sensitivity Analysis: B/C \$9/cwt milk \$76.50 / \$ B/C 8# milk response \$81.60 / \$ B/C \$0.09/lb feed \$ / ( ) 1.62 B/C +20% utilities \$ / ( ) The \$85/cow represents the amount required to purchase and install fans and sprinklers and the is an amortization factor to reflect the annual depreciation and interest cost (based on 5-year life and 8% interest). 2 This is the breakeven milk price to cover the costs associated with the cooling system (i.e., breakeven price on the incremental milk production). Thus, so long as milk prices are at this level or greater it is economically advantageous to install the cooling system even though the dairy may not be covering total costs. Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 124

19 Table 8. Partial Budget Analysis for POSILAC on a 1,000 cow dairy Intervention Benefits: (1) Increased Revenue Increased milk 10 lb/day x \$12/cwt x 1000 cows \$1200 per day (2) Decreased Costs None \$0.00 Total Benefits (B) \$1200 Intervention Costs: (3) Decreased Revenue None \$0.00 (4) Increased Costs POSILAC \$5.85 / 14 days x 1000 cows \$418 Feed costs 4 lb feed \$0.07/lb x 1000 \$280 Labor costs \$0.01/cow/day x 1000 cows \$ 10 Total Costs (C) \$708 per day Profitability of Intervention Benefits minus Costs \$1200 \$708 \$492 per day Benefit-Cost (B/C) ratio \$1200 / \$ Breakeven Analysis: Breakeven milk price 1 \$708 / (10 lbs x 1000 cows) x 100 \$7.08 per cwt Sensitivity Analysis: B/C \$9/cwt milk \$900 / \$ B/C 8# milk response \$960 / \$ B/C \$0.09/lb feed \$1200 / (\$418 + \$360 + \$10) 1.52 B/C \$25/day labor \$1200 / (\$418 + \$280 + \$25) This is the breakeven milk price to cover the cost of the POSILAC (i.e., breakeven price on the marginal milk production). Thus, so long as milk prices are at this level or greater it is economically advantageous to use POSILAC even though the dairy may not be covering total costs. POSIALC is a registered Trademark of Monsanto Technology, LLC. Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 125

20 Table 9. Cost-Return Projection --- 2,400 Lactating Cow Freestall Dairy (replacements purchased) Production level (lbs milk sold) 19,000 24,000 per cow per cwt per cow per cwt RETURNS PER COW 1. Milk \$13.23/cwt. \$2, \$13.23 \$3, \$ Volume premium Government payment (MILC) Calves sold: 95% x \$200/head Cull cows sold: 1,400 lbs x 28% x \$58.41/cwt A. GROSS RETURNS \$3, \$15.99 \$3, \$15.52 VARIABLE COSTS PER COW: 6. Feed (from Table 3) \$1, \$5.56 \$1, \$ Labor Veterinary, drugs, and supplies Utilities and water Fuel, oil, and auto expense Milk hauling and promotion costs Building and equipment repairs Breeding/genetic charge: a. Capital replacement: 34% x \$1600/head b. Semen, A.I. services, and supplies c. Interest d. Insurance Professional fees (legal, accounting, etc.) Miscellaneous Depreciation on buildings and equipment Interest on land, buildings, and equipment Insurance and taxes on land, buildings, and equip B. SUB TOTAL \$3, \$16.00 \$3, \$ Interest on 1/2 operating 7.0% C. TOTAL COSTS PER COW \$3, \$16.35 \$3, \$14.58 D. RETURNS OVER TOTAL COSTS (A - C) -\$ \$0.36 \$ \$0.94 E. BREAKEVEN MILK PRICE, \$/cwt: \$13.59 \$ Lactating cow feed cost, \$/head/day \$3.18 \$ Dry cow feed cost, \$/head/day \$1.11 \$1.46 F. ASSET TURNOVER (A/Assets) / % 89.60% G. NET RETURN ON ASSETS ((D + 13c )/Assets) /1 5.04% 12.40% /1 Assets equal total value of breeding herd and land, buildings, and equipment. Proceedings of the 7 th Western Dairy Management Conference March 9-11, 2005 Reno, NV 126

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