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Collective Review of the Financial Statements

Excerpt from Reff, T.L. and D.M. Saxowsky.

Analyzing Your Farm Financial Statements,

NDSU Extension Service, EC-920, January 1987

Only in rare instances will the "bottom line" on each financial statement for a business (balance sheet, cash flow statement and income statement) indicate similar results; for instance, net worth increased by $10,000, while a positive cash flow of $10,000 was realized, and the income statement reports a $10,000 profit. Almost inevitably, the numbers will be of varying amounts and may even be opposite in sign; for example, net worth decreased although the income statement reported a profit for the year. A farm operator should not expect nor strive for the same "bottom line" on each financial statement, but comparing outcomes will reveal something about the business. Consequently, farm operators must review all three statements to more fully understand their business.

This page has two purposes; the first is to explain reasons for variation among the "bottom lines" of a farm's financial statements; for instance, why is the level of profit greater than the increase in net worth. The second purpose is to suggest interpretations for various combinations of "bottom lines;" for example, what does it mean if a business's net worth increased during the year and its overall cash flow was positive but its operation was unprofitable. An awareness of the reasons for variation improves interpretation of the financial statements and understanding of the farm business.

REASONS FOR VARIATION AMONG FINANCIAL STATEMENTS

Each financial statement requires distinctive data in its preparation and provides unique information. These differences, when coupled with the myriad of farm business transactions and the complexity of our economy, assure that the "bottom line" of each statement will vary. Table 1 summarizes some causes of the variations.

Table 1. Causes of Variation Among a Farm Business' Change in Net Worth, Level of Profit, and Overall Cash Flow.

LEVEL OF PROFIT DIFFERS FROM CHANGE IN NET WORTH

Net worth or equity in a business increases as a result of any one or a combination of three factors, which are:

1. profitable operation,
2. inflation increasing the value of business assets, and
3. the owner contributes additional resources to the business by converting assets from a nonfarm use to a farm application.

The three opposite transactions reduce a business's net worth; these are unprofitable operation, deflation, and owner withdrawals. Therefore, any variation between a farm's level of profit for the year and the change in the business's net worth is a consequence of (1) change in market value of the business assets and (2) the owner's contributions or withdrawals. Most farm families find the level of profit to be greater than the increase in the business's net worth because withdrawals for personal living expenses are necessary if the farm operation is the major source of the family's income.

OVERALL CASH FLOW DIFFERS FROM LEVEL OF PROFIT

The basic reason for a difference between the overall cash flow and the level of profit is that some cash inflows are not considered income and some cash outflows are not operating expenses. Furthermore, some expenses do not require a cash outflow and some income does not generate a cash inflow. Family living expenses, capital acquisitions or improvements, and principal portion of a debt repayment are examples of cash outflows (or withdrawals) that are not deducted when computing profit. Consequently, the overall cash position will exceed the business's level of profit. The result is just the opposite when cash derived from another source is invested in (contributed to) the farm business.

The adjustments on the income statement further explain why the overall cash flow and level of profit differ. These adjustments include change in inventory, accounts receivable and accounts payable. There is income for the purpose of determining profit when the inventory of supplies or commodities grows, when accounts payable decrease, or when accounts payable increase but there is no corresponding cash inflow. There is a negative effect on the level of profit without a cash outflow when the opposite occurs. For example, retaining a significant portion of a year's produce as stored inventory (without acquiring a Commodity Credit Corporation loan) will cause profit to exceed cash inflow.

Similarly, a cash flow statement does not include all costs of operating a business; it is a record of only those expenditures that require a cash outflow. Depreciation is an example of a cost that does not require a corresponding cash outflow. Commodities produced with depreciable assets will be sold for cash yet the amount needed to compensate for depreciation will not necessarily be paid out as cash. Therefore, it is possible that the business will have more cash than profit because income from using depreciable equipment is retained as cash rather than used to replace or improve machinery. It is important to realize that using equipment to produce commodities that are sold for cash is really liquidation of the equipment over time.

Generally, borrowing additional money will not affect the business's level of profit or the cash flow position if the loan proceeds are used to purchase a business asset. In that case, the cash inflow (loan proceeds) equals the cash outflow (purchase price) so there is no change to the cash flow position. Furthermore, the expenditure is not deductible as an operating expense and has insignificant impact on the level of profit. On the other hand, using loan proceeds for an operating expense will reduce the business's level of profit but not affect the overall cash flow. The only other way borrowing money will increase the cash position without affecting the level of profit is for the money to be borrowed but not spent. This will not happen often since prudent business operators will recognize that such activity is likely to be unprofitable.

OVERALL CASH FLOW DIFFERS FROM CHANGE IN NET WORTH

Similar reasons explain why the overall cash flow position would differ from the change in net worth. Non-cash contributions and withdrawals are one example. Converting an asset from a use in the farm operation to a non-farm purpose decreases the amount of assets that, in turn, diminishes the owner's equity in the business. Such conversions do not involve cash and therefore are not part of the cash flow and have no impact upon it. Inflation and deflation of asset values also affect net worth but do not involve a cash flow or a business transaction.

As explained above, a business's depreciation allowance is being converted to cash if it is not used to replace or improve depreciable assets. This does not affect the owner's net worth in the farm operations unless the cash is withdrawn from the business. Consequently, change in net worth will be different from the farm operation's overall cash flow position to the extent the depreciation allowance is not reinvested in business assets but instead is used for operating expenses or withdrawn and used for non-farm purposes such as family living. This is sometimes referred to as "living off of depreciation."

Repaying principal portion of a debt or purchasing capital assets are cash outflows but do not affect net worth since the transactions simply convert the form of the asset from cash to equipment or land. Similarly, changes in inventory, accounts payable and accounts receivables affect net worth without a cash transaction. The result of these transactions is that the overall cash flow position will not equal the owner's change in net worth.

Generally borrowing additional money will not affect the business's net worth or the cash flow position if the loan proceeds are used to purchase a business asset. In that case, the cash inflow (loan proceeds) equals the cash outflow (purchase price) so there is no change to the cash flow position. Furthermore, the new debt will equal the value of the recently acquired asset so there is no change in the net worth of the business. On the other hand, withdrawing the loan proceeds from the business and using them for a non-farm use will reduce the business' net worth but not affect the overall cash flow. Therefore, the only way borrowing money will increase the cash position without affecting net worth is for the money to be borrowed and not spent. As suggested earlier, this will not happen often since prudent business operators will recognize that such activity is likely to be unprofitable.

There are numerous reasons why the "bottom line" of the three financial statements will vary and the preceding discussion identified some of the reasons. The following section suggests interpretations for these differences.

INTERPRETING THE "BOTTOM LINES"

Numerous combinations of "bottom lines" are possible when the three financial statements are compared. These combinations follow eight patterns. Table 2 illustrates these eight patterns and can be used as a guide to understand the remaining discussion on this page. Reference to the balance sheet means the extent a business' net worth changed since preparation of the previous balance sheet. For example, what is the net worth as of January 1, 1986 compared to the net worth as of January 1, 1987. A positive change means the net worth increased during the year (1986) while a negative change indicates a decrease. Positive cash flow describes a situation where total cash inflows during the year exceeded the cash outflows. A negative cash flow refers to the opposite condition. A positive income statement means a profit was generated during the year whereas a negative inome statement describes a year during which the business incurred a loss.

Table 2. Possible Patterns of Outcomes for Financial

Statements of a Business.

Throughout this discussion, it has been necessary to distinguish between farm business and non-farm activities and that distinction continues to be important. The remaining discussion considers only the farm business portion when determining the change in net worth and profit or loss whereas farm and nonfarm are combined when considering the cash flow. This different treatment is warranted because the goal is to analyze the family farm business rather than the family's total income or property holdings. The family will want to determine what is happening to the net worth of its farm and whether it is profitable or incurring a loss. Total cash flow is considered, however, because business owners are likely to use cash from whatever source to continue operation of their farms during a given year.

*Situation 1 - Increased Net Worth, Positive Cash Flow and Profit

This is the situation (as shown in the Appendices) all business owners desire; the farm was profitable (a net farm income of $26,973), the owner's net worth increased by $11,482 ($460,692 - 449,210), and the farm generated a positive cash flow of $14,991. However, more can be learned about the operation because the dollar amount of profit, increase in net worth, and positive cash flow are not the same.

Withdrawing cash from the business to meet family living expenses depletes the business's cash reserve and its owner's equity but does not alter the level of profit. It is possible to determine the amount the family withdrew from the farm operation. According to the cash flow statement and income statement, the family spent $23,000 cash on non-farm expenses (that is, $19,200 family living, $620 non-farm vehicle expense, and $3,180 for income and self-employment taxes). Total cash received from non-farm sources was $7,262 (off-farm wages of $6,912 and interest income $350). This means $15,738 ($23,000 - 7,262) was withdrawn from the farm to meet non-farm expenses. Having withdrawn $15,738 dollars for non-farm expenses from the farm's profit of $26,973 leaves $11,235 ($26,973 - 15,738) to reinvest in the business and increase the owner's net worth. Since net worth increased by $11,482, the remaining approximately $250 ($11,482 - 11,235) must have been gained through inflated values of business assets. The operator would now know more precisely how the farm's profit was being used.

Cash flow for the farm operation, although it was positive, was significantly less than the level of profit ($14,991 positive cash flow compared to $26,973 profit). Note that the positive cash flow from the farm operation ($14,991) minus the amount withdrawn from the business ($15,738) equals the overall cash flow ( -$747).

Having a positive cash flow in excess of the business profit may sound like a desirable situation but operators must be careful not to misunderstand what is occurring. The reasons presented above as to why cash flow may exceed the level of profit have a common characteristic of liquidating assets of the farm operation. Unless this cash is reinvested in the business or set aside for future reinvestment, there may not be sufficient cash to re-equip the farm once the current assets have been consumed. Cash in excess of profit may mislead an uninformed business owner to take actions that can have long-term negative implications, such as increasing family living expenditures.

*Situation 2 - Increased Net Worth, Positive Cash Flow, but Loss

As stated above, the primary reasons for increasing net worth are profitable operation, inflation, or owner's contributions. This situation assumes a loss is incurred (rather than profit) so any increase in net worth is due solely to inflation of asset values or added investment. Assuming a minimum amount of non-farm assets is converted to the farm operation, total impact of inflation can be calculated by adding the amount of loss and the increase in net worth.

Relying solely on the change in net worth as revealed by the balance sheet can mislead a farm operator and lender to conclude that the operation is profitable. This may have been the case during the late 1970s. Rapidly inflating land values compensated for low profitability, and without preparing an income statement there was little opportunity to recognize what was occurring. Inflation is easily misinterpreted as profit.

Cash flow can be positive even though a loss is incurred. The same explanations presented as to why an overall cash flow position can exceed amount of profit also apply here. Situation 2, however, is characterized by rapid inflation so the most likely explanation of why overall cash position would be positive even though the operation incurred a loss would be that additional funds were borrowed based on an increased net worth.

*Situation 3 - Increased Net Worth, Negative Cash Flow, but Profit

For purpose of comparing profit to net worth, the ideas expressed in a preceding section (Level of Profit Differs from Change in Net Worth) address whether the increase in net worth is due to profit, inflation, owner's contributions, or a combination of the three. Operators must be aware that if profit is greater than the increase in net worth, there may have been deflation of business asset values (but it was less than the amount of profit) or the operator made withdrawals from the business. The dollar impact of inflation can be determined as:

Amount of inflation = change in net worth - net farm profit - contributions + withdrawals

Change in net worth can be observed from the two balance sheets whereas net farm profit is found on the income statement. Withdrawals and contributions may require some further computations, but the idea is to compare the amount of cash and assets withdrawn from the farm and used for consumption or non-farm investment to the amount transferred from non-farm sources to the farm operation. The cash flow statement may be of considerable assistance in identifying these transfers, but other informational sources will be needed for non-cash transactions.

This situation also addresses when net farm income is positive but the business experiences a tight cash flow. Reasons for a profitable business to experience a tight cash flow include increases in inventory, repayment of debt principal, and acquisition or improvement of capital assets such as buildings, breeding livestock, or equipment. Excessive withdrawals from the business should not be the cause of the tight cash flow unless the increase in net worth is a result of inflation. A farm operation experiencing tight cash flow even though it is profitable is likely to warrant additional credit if it appears reasonable that the business will continue to be profitable and regain its ability to pay its cash obligations by altering its cash spending practices.

*Situation 4 - Increased Net Worth, but Negative Cash Flow and Loss

Although a business's net worth can be increased by the owner transferring non-farm assets to the farm operation, the most likely explanation for an increase in net worth is due to inflating business asset values and that the amount of inflation was greater than the operation's loss. A person who extensively relies upon only the balance sheet to analyze the farm operation is not likely to recognize the seriousness of the situation. The ideas expressed in the discussion of Situation 2 also apply in this case.

Farmers and lenders must be careful not to be misled into further borrowing based on increased net worth without understanding why there is a tight cash flow. Depreciation should permit negative cash flow to be less than loss if the depreciation allowance is not spent on replacement. This may be an appropriate time to temporarily "live off of depreciation" if the farm can reasonably be expected to again be profitable in the near future.

If it is not readily apparent why there was a loss, it may be helpful to compare the current year's income statement and production records with those of past years. Was the loss due to reduced yields, poorer prices, increased costs, negative adjustments, or combination of these? These factors also can cause negative cash flow.

*Situation 5 - Decreased Net Worth, but Positive Cash Flow and Profit

Again net worth is influenced by market pressures on asset values (deflation in this case) to such an extent that value decreases exceed the profit earned by the farm. Excessive withdrawals for consumption and family living also can cause a profitable operation to experience a diminishing net worth, but this is not likely the case; otherwise the cash flow would be tighter. Therefore, the focus will be upon a method to identify the dollar impact of deflation.

Deflation can be estimated with a formula that simply restates the ideas discussed in Situation 1. The formula would be:

Amount of deflation = change in net worth + net farm profit + contributions - withdrawals

The sources of this information are the same as explained in Situation 3. The relation between cash flow and profit level of business would be the same as discussed in Situation 1.

*Situation 6 - Decreased Net Worth, Positive Cash Flow, Loss

Sufficient cash flow but negative net farm income can arise when stored inventory is sold or when capital expenditures necessary to replace depreciation are not made. This is "living off of depreciation" and cannot continue.  Adequate cash and a loss also can occur when assets are sold with the proceeds used to pay cash obligations.

An important step in this situation is to determine why net worth decreased; was it due to the loss, deflation, withdrawals, or a combination of the three. If the decrease in net worth is less than the loss, asset values are likely to have inflated and partially offset the operating loss. If the decrease is greater than the loss, the difference is due to withdrawals or deflation. The impact of these two factors can be distinguished by calculating the amount of withdrawals (less any contributions) and comparing it to the difference between net worth decrease and loss. Deflation is the likely explanation why the difference would be greater than withdrawals. There was no deflation if withdrawals exceed the dif­ference.

This is a situation of survival in the short run. Profits must be made soon to turn this situation around.

*Situation 7 - Decreased Net Worth, Negative Cash Flow, but Profit

Again net worth is diminished by deflation of asset value similar to situation 5, but the negative cash flow is due to circumstances similar to those described in situation 3; i.e. cash outflow was used to acquire assets and services not considered expenses on the income statement. This may be the situation many operators are experiencing during the 1980s. The operation is profitable but decreasing asset values are reducing net worth. More significantly, excessive principal payments are depleting cash resources and leaving the operation unable to repay its debts. This combination is rendering it more difficult for the heavily indebted farm to continue operating even though the value of its produce may be greater than the variable cost of producing it.

This situation also may result from excessive withdrawals from the business for family living or non-farm investments even though the impact of inflation or deflation is insignificant. If that is the case, withdrawals should be reduced at least enough to eliminate the negative cash flow. Withdrawals will need to be further reduced if the decrease in net worth begins to adversely affect the profitability of the farm operation.

*Situation 8 - Decrease Net Worth, Cash Flow and Profit are Negative

This has been a common situation for those in serious financial condition. Equity has been eroding due to deflation in land values and inability to pay debts. (Unpaid interest is accumulating, which causes the decrease in net worth and loss.) Cash flow is negative because of lower prices for commodities and/or low yields, high interest costs and debt obligations. Profits are negative because of the cost/price squeeze and reduction of inventories.

The magnitude of the negative amounts or decreases on the three financial statements is more important than the fact that they are negative. However, the warning signs are there and steps must be taken to turn the situation around or the situation will worsen rapidly.

Summary

Generally, the positive change in net worth on the balance sheet, to the extent it is greater than the profit shown on the income statement, is due to inflation. Inflation and deflation can affect the balance sheet to offset or augment the change in net worth as a consequence of profit or loss (as observed from the income statement).

Cash flow is not a measurement of profit or loss. It merely records whether the operator had access to cash to meet obligations as they came due.

It is possible for a business to experience a loss on the income statement yet generate a positive cash flow. This combination is often the consequence of liquidating inventory or equipment. Creditors are probably interested in the cash flow since they demand repayment in cash. The owner/operator, in addition to being interested in satisfying creditors with cash repayment, should be concerned about the business's long-term financial condition. Therefore, a loss on the income statement must be given serious review even though the operation can generate a positive cash flow.

Last updated September 20, 2010

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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