Balance sheets and statements of net worth both include assets and liabilities. The difference between the two is that a statement of net worth will have capital assets, such as land and quota, reported at fair market value. Balance sheets have capital assets valued at original cost, minus amortization for depreciable assets, such as buildings and equipment.
Assets minus liabilities equals equity. As a farmer, assets are what you own. Liabilities are what you owe. Equity is what’s yours. Another explanation is that assets always equal liabilities plus equity — it’s a formula and it has to be in “balance.”
Retained earnings is an alternative way of expressing equity and usually used as the descriptor in balance sheets. Changes from one year’s balance sheet to another is a function of profit, or earnings, for the year. Obviously, a farmer would want to see their retained earnings increase from year to year. But, if a farm loses money in a year, there would be a decrease in retained earnings from one year to the next. Changes in retained earnings are a function of earned financial progress.
Shifts from one year’s statement of net worth to another include profit but also can include increases in the fair market values of capital assets. This is generally referred to as unearned financial progress because the increase in the value of land, for example, was not directly related to profit generated from operations.
An income statement summarizes revenue and expenses for any given period of time. At a farm’s year-end, it will be for the past year. Cost of production analysis gets lots of attention as farmers make decisions around rotation, inputs, including rations and feed costs for livestock enterprises, and marketing. Cost of production correlates directly with profit and profit is the engine that drives the business. This is important. As we all know, margins are narrow and costs are increasing. However.…
An observation I have, shared by many others, is that balance sheets, or statements of net worth, do not receive the attention they deserve.
Farm businesses should strive to drive wealth into their business. Simply stated, owners should want their businesses to be worth more each year. The wealth, measured as equity, has many potential uses:
- To leverage (borrow against) to fund growth and reinvestment.
- To support inter-generational transition.
- To sustain a business through periods of time when profit is low or losses occur, resulting in weak or non-existent cashflow and a requirement to restructure the debt in the business.
- To leave a legacy.
Trend-line analysis is key when looking at balance sheets and statement of net worth. The structure of the balance sheet should be monitored closely. There are typically two categories for assets and liabilities — current and term. It is important to track the relationship between current assets and current liabilities because these correlate closely with liquidity or cashflow.
Further, it is important to track the relationship between current and term liabilities. How much of the total debt of a farm is due in the next year — current refers to the next 12 months. A farm’s current liabilities are the liabilities that must be paid in the next year.
A common year-end date for farms is Oct. 31, Nov. 30 or Dec. 31. Of course, a year-end date can be at any point of time during a year. There are reasons why year-end dates other than a calendar year-end are chosen. A year-end is a great time to look at your balance sheet or statement of net worth.
If you are not incorporated, record your assets and liabilities at Dec. 31 every year. It is common to find unincorporated farms that will have, for example, a statement of assets and liabilities at Nov. 30 one year, Feb. 15 another, perhaps March 31 on another and maybe even be missing one or two years. This sporadic approach to recording assets and liabilities makes it extremely difficult to capture accurate information that can be used to analyze trends in financial performance and perhaps, support a loan application or be used to discuss the financial implications of inter-generational transition.
It’s generally accepted that “if you can’t measure it, you can’t manage it.” There are numerous ratios and indicators — the measurements — that can be used to manage financial performance on a farm. A key measurement looks at the relationship between the assets and liabilities of the business. The analysis and related management require that a preliminary step be taken that first defines what is actually being measured. Balance sheets are a great place to start!
Terry Betker, PAg, is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or firstname.lastname@example.org.