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Management

Agriculture in the 21st Century
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Labor

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Information

Risk

Management

Financial Statements

The emphasis of this subsection is on concepts and techniques to analyze business alternatives; many of the tools address quantitative analyses. This page addresses several management and economic concepts:

  • Financial statements (balance sheet, income statement, cash flow)
  • Financial analysis (return on assets and return on equity)
  • Opportunity Cost
  • Depreciation

 

Financial statements  (information based on the business' internal financial records)

The following points briefly review the key points of financial statements frequently used by businesses. The assumption is that these financial statements have been introduced and studied in detail in other courses.

1. Balance sheet or net worth statement

  • Summarizes the business' assets, liabilities, and net worth or equity
  • A balance sheet is prepared as of a particular point in time, such as December 31, 200X.
  • All owned assets and their values are listed. All debts owed also are listed. The difference between the total value of the assets and the total liabilities is the owners' equity.
    • Why is it important to know the assets, liabilities, and equity of the business?
    • How does equity in the business relate to the owner's capacity to assume risk?
      • Review -- What is the difference between capacity/ability to assume risk and willingness to assume risk? How does one's capacity to assume risk change over time and how does one's willingness to assume risk change over time? What is the practical implication of these two trends?
      • Review -- what is the relationship between ability to assume risk as revealed by a balance sheet and a common business goal of accepting a reasonable level of risk exposure?

     

  • Another balance sheet could be prepared at another time, maybe three months later, maybe a year later. The values on the two balance sheets will likely be different. For example, a comparison of equity calculated on balance sheet 1 and the equity calculated on balance sheet 2 reveals how the owners' equity changed during the time between the dates the two balance sheets were prepared.
    • Review -- what is the relationship between change in equity as revealed by a series of balance sheets and the common business goal of increasing equity or net worth?

 

  • What transactions impact the balance sheet? What are some simple examples?
    • Sale of inventory for cash would decrease the quantity of inventory (an asset) and increase the amount of cash (another type of asset). Total assets should not change, nor should total liabilities or equity. This transaction primarily changes the form of the business assets; that is, from physical items in inventory to cash.
    • Cash used to pay principal on a loan decreases the amount of cash (an asset) a business has; liabilities should decrease (by the same amount); equity should remain unchanged.
    • Purchase a piece of equipment by borrowing the purchase price. Total assets and total liabilities should increase; equity should remain unchanged.
    • Purchase a piece of equipment by using cash to pay the purchase price. Cash (an asset) should decrease), equipment (an asset should increase), total assets, total liabilities and equity should remain unchanged. The transaction changed the form of the asset -- cash to equipment.
    • How should warranties and growing crops be treated in preparing a balance sheet?
    • How might the payment of an interest expense or operating expense impact a balance sheet?

 

2. Income statement

  • Summarizes the business' revenue, cost and profit
    • Be careful to appropriately use these terms; for example, it is easy to interchange revenue and profit, but they are different concepts.
  • "Preparing an income statement" is a process to calculate the profit of an entire business; an income statement is a document that summarizes the data and information used to calculate the business' profit.
    • Review -- It is assumed that earning a profit is a goal for the business owners, but it may not be the only goal.
    • What is the relationship between the common business goal of earning a profit and an income statement?

     

  • An income statement covers a period of time; for example, January 1, 200X to December 31, 200X.
  • An income statement can be prepared to 1) "report the past:" that is, what profit was generated during a past period, and 2) "project the future;" that is, what profit is expected to be generated during a future period.
  • Revenue is the value of all production during the period of time. It includes items produced but not sold; it does not include items sold from inventory that had been produced during an earlier period.
  • Cost is the expense associated with the items produced during the time period.
    • In a closely-held business, it is important to distinguish between a business expense and a non-business (family) expense. For example, the insurance premium paid to protect against the risk that a business building might be damaged by a storm is a business expense, whereas the insurance premium paid to protect the family residence is not a business expense.

 

  • The question an income statement answers is whether the business generated a profit by producing its product during the time period.
    • Recognize that income tax law may allow a business owner to treat some expenditures differently for income tax purposes than it would be treated for calculating the business profit. In this course, the emphasis is NOT on income tax practices.

 

  • All revenue may not be cash; some production may have been added to inventory. All expenses may not require a cash payment; e.g., depreciation of equipment is not a cash expense, but it is an expense or cost.
    • Depreciation is a cost, but what is depreciation?
      • Do not allow "managing depreciation for income tax purposes" to interfere with understanding depreciation for management purposes. These are distinct topics and should be addressed as distinct topics.
      • In managing depreciation for tax purposes, the manager will strive to make decisions, as allowed by federal income tax law, to maximize the business' after-tax income.
      • In understanding depreciation for management purposes, the manager will strive to develop and follow a depreciation method that results in an accurate statement of costs and net income, without income tax considerations.
      • Depreciation for purposes of management can be described as a procedure to allocate or assign a portion of the cost of an asset to each production period during which the asset is used.
    • An example of calculating depreciation based on a question from a farm manager (who also is a former student).
    • Also see Cost v. Cash Outflow

     

  • All expenses are not recognized on an income statement; for example, the value of the owners' time is an opportunity cost (recognized by the managers), but is not a cost that accountants include as an expense when preparing an income statement. That is a difference between how managers analyze a business and how accountants analyze a business. This discussion focuses on how managers analyze a business. More on opportunity cost in a subsequent section.
    • How does a manager determine whether the business generated an adequate profit?
    • Review -- what is the relationship between profit as calculated with an income statement and the common business goal of earning a profit?
  • Resource: Kay, et al. Farm Management, McGraw Hill, 5th Ed. 2004, chapter 6.
  • Resource: Edwards, W. Your Farm Income Statement, Iowa State U. File C3-25
  • Sample of manual financial statements

 

3. Cash flow statement

  • Documents the business' cash inflows and cash outflows
    • What is the relationship between a cash flow statement and the common business goal of wanting to pay the business' obligations when they are due?
  • Like an income statement, a cash flow statement covers a period of time; for example, January 1, 200X to December 31, 200X.
  • A cash flow statement can be prepared to 1) "report the past," that is, what cash inflows and outflows occurred during a past period, or 2) "project the future," that is, what cash inflows and outflows are expected to occurred during a future period.
    • Projected cash flow is sometimes referred to as "a cashflow budget."

     

  • A cash flow statement includes all cash flowing into the business and all cash flowing out of the business. It includes cash flowing into the business from the sale of produce and cash flowing out of the business from the purchase of production inputs or operating expenses. But it also includes cash the owners' contribute to the business in an attempt to expand the business; as well as the cash the owners remove from the business to compensate themselves for being invested in the business.
    • For example, in many closely-held businesses, the owners may try to withdraw enough cash to pay all or part of the owners' family living expenses.

 

  • The purchase of a long-term asset, such as a piece of equipment, requires cash, and thus appears as a cash outflow on the cash flow statement. However, the cost of the equipment does not appear as an expense on the income statement. Only the amount that the equipment is depreciated during this first time period will appear as an expense on the current income statement. The difference between cash flow and revenue/expenses is addressed in more detail in a subsequent section.

 

  • Borrowing cash is a cash inflow on the cash flow statement, but is not revenue on an income statement. Again, the difference between cash flow and revenue/expenses is addressed in more detail in a subsequent section.
  • Likewise, paying part of the principal portion of a debt is a cash outflow on the cash flow statement, but not an expense on the income statement.
    • Even though lenders often review a borrower's balance sheet in assessing whether to extend a loan, would there be any reason for the lender (as well as the borrower) to assess the borrower's projected cash flow in deciding whether the loan should be made?
    • Review -- what is the relationship between projected cash flow as revealed by a cash flow budget and the common business goal of paying obligations on time?

 

 

Example of financial statements following a series of business transactions. This example is intended to illustrate how individual transactions impact each financial statement.

 

Financial analysis

As an introduction to this subtopic (financial analysis), consider "why do we organize this information about our business into these documents or statements?" What is the purpose of preparing these financial documents? What is the purpose of analyzing this financial information (as we will discuss in this section)? How do the answers to these questions relate to topics previously discussed in this course?

  • HINT -- review the role of goals in the decision making process; also recognize (do not overlook) that goals play a role in several steps of the decision making process.

     

  • Review -- what does the balance sheet reveal about the business? What does the income statement reveal about the business? What does the cash flow statement reveal about the business?

 

  • What does a series of balance sheets reveal about the business? What does an income statement for the past reveal and what does an income statement for the future (a projected income statement) reveal? What does a projected cash flow statement reveal?

     

  • What do these statements collectively reveal? (see the next topic)

 

 

Return on Assets, Return on Equity, etc

  • Rate of return on assets (ROA) -- profit plus interest expense for the time period (as calculated on the income statement) minus opportunity cost for unpaid labor and management divided by the total value of assets (as reported on the balance sheet).
  • Income statement reports adjusted profit of $12,000 for 200X; the balance sheet reports total assets of $200,000; this would be a rate of return on assets of 6%
  • If there is a major change in value of assets during the period being analyzed (as revealed by the balance sheet from the start of the period and the balance sheet from the end of the period), a manager may want to average the value of the assets from the two balance sheets to determine the value of assets to use in computing return on assets.
    • Example. The income statement reports profit of $12,000 for 200X and the balance sheet on January 1, 200X reports assets of $100,000 whereas the balance sheet on December 31, 200X reports assets of $200,000. The average assets for 200X would be $150,000, for a rate of return on assets of 8% (12,000/150,000).

 

  • Rate of return on equity (ROE) -- profit for the time period (as calculated on the income statement) minus opportunity cost for unpaid labor and management divided by the equity as calculated on the balance sheet.
  • $12,000 adjusted profit from a business with $110,000 equity would be earning a rate of return on equity of 10.9%.

 

  • A business; ROE should be greater than its ROA. This indicates that the business is increasing its profit by borrowing. If ROA exceeds ROE, the business may want to consider whether it wants to use some of its assets to reduce its debt.
  • An ROE that exceeds an ROA is consistent with the idea that the business is assuming additional risk by borrowing to expand its business. The additional profit (as indicated by ROE > ROA) is consistent with the idea that successfully assuming risk leads to additional profit.

 

 

Financial Goals

  • Again, what role do goals (financial as well as other goals) have in decision making?  What process can be used to establish short- and long-term business and personal goals?

     

  • What goals might a business have other than earning a profit? What goals other than earning a living might an individual have?

     

  • What aspect of financial management or financial analysis can an accountant perform and what aspect of financial analysis must the manager perform? Why?

     

Opportunity Cost -- everything has a cost! Why do we make this statement? How does the answer to that question relate management?

    • Why does a manager think about opportunity cost?
      • What is the relationship between opportunity cost and the common business goal of wanting to earning a profit?
    • Why does an accountant probably not think about opportunity cost? What information is the accountant lacking?

     

    • Which is the relevant financial statement when a manager is thinking about opportunity cost?
    • How do managers incorporate the concept of opportunity cost into their thinking?
    • Now, how do you describe opportunity cost?

     

Summary of Key Points

This web page addressed several critical management topics.

  • A balance sheet summarizes the business assets and their values, the business debts, and the owner's equity in the business. This information provides some insight into the business ability or capacity to assume risk.
  • An income statement calculates the profitability of the business.
  • A cash flow statement (especially a projected cash flow) helps the manager identify whether there will be enough cash to pay obligations when they are due. Cash flow statement also provides an indication of when and how much cash may need to be borrowed, or when and how much cash the business may have available.
  • Revenue and expenses are different from cash inflow and cash outflow.
  • Financial goals provides the manager a basis for establishing opportunity costs; that is, how much profit must the business return to the owner to keep the owner invested in the business.
  • Depreciation is the allocation of cost of an asset among the time periods when the asset is used.

 

The next section is an opportunity to consider several selected economic concepts.

 

Last Updated November 6, 2009

   

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

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