Farm Management Chapter 6 The Income Statement and Its Analysis
Chapter Outline • Identifying Revenue and Expenses • Income Statement Format • Accrual Adjustments to a Cash-Basis Income Statement • Analysis of Net Farm Income • Change in Owner Equity • Statement of Cash Flows • Summary
Chapter Objectives • Discuss the purpose and use of an income statement • Illustrate the structure and format of an income statement • Define the sources and types of revenue and expenses included • Show how net farm income is computed and what it means • Analyze farm profitability
What is an Income Statement? An income statement is a summary of revenues and expenses as recorded over a period of time.
Identifying Revenue and Expenses • Revenue: revenue should be recognized as soon as a commodity is ready for sale, whether or not it is actually sold • Gain or loss on sale of capital assets: difference between sale price and book value • Expenses: all expenses incurred in producing the revenue for an accounting period should be included
Income Statement Format Total revenue Less total expenses Equals net farm income from operations Plus or minus gain/loss on sale of capital assets Equals net farm income
Accrual Adjustments to a Cash-Basis Income Statement • The FFSC recommends that anyone using cash accounting convert the resulting net farm income to an accrual-adjusted net farm income at the end of each year • Two adjustments to cash receipts: change in inventory values and accounts receivable • Several adjustments to expenses, including accounts payable and accrued expenses
Figure 6-2 Adjustments to get accrual-adjusted net farm income from a cash-basis income statement
Table 6-3 Income Statement for I.M. Farmer for Year Ending December 31, 2010
Net Farm Income Net farm income is the amount by which revenue exceeds expenses, plus any gain or loss on the sale of capital items. It represents the return to the operator for unpaid labor, management, and equity capital. Net farm income from operations excludes gain or loss on sale of capital items.
Analysis of Net Farm Income • Rate of return on assets • Rate of return on equity • Operating profit margin ratio • Return to labor and management • Return to labor • Return to management
Opportunity Costs of Labor and Management The opportunity cost of unpaid labor is the estimated amount that any unpaid farm labor could have earned elsewhere. The opportunity cost of management is the estimated amount that the operator could have earned for that management time had it been used in paid work.
Rate of Return on Assets(ROA) Rate of return return to assets ($) average farm asset = 100% on assets (%) value
ROA for I.M. Farmer $ 51,300 = 100% ROA $725,750 = 7.07%
Rate of Return on Equity (ROE) Rate of return return on equity ($) average equity ($) = 100% on equity (%)
ROE for I.M. Farmer $ 21,800 = 100% ROE $358,565 = 6.08%
Comparing ROA and ROE If ROA > i then ROE > ROA If ROA < i then ROE < ROA Wherei is the interest rate on borrowed capital. Thus, if ROA > ROE borrowed capital is earning, on average, less than the interest rate. If ROA < ROE, borrowed capital is earning, on average, more than the interest rate.
Operating Profit Margin Ratio operating profit Operating profit margin ratio 100% = total revenue
Operating Profit Margin Ratio for I.M. Farmer $ 51,300 Operating profit margin ratio 100% = $200,400 = 25.6%
Opportunity Cost of Capital To find the opportunity cost of capital, multiply the opportunity interest rate (e.g. what the capital could earn elsewhere) times the average total asset value. For I.M. Farmer: $725,750×8% = $58,060
Change in Owner Equity • Retained farm earnings: the part of farm earnings, after taxes and personal withdrawals, that is retained for use in the farm business • A positive retained farm earnings increases owner equity • If taxes and living expenses are greater than total earnings, owner equity will fall
Statement of Cash Flows • A summary of actual cash inflows and outflows over an accounting period • Operating: cash farm income and expenses • Investing: capital assets • Financing: loans and repayments • Nonfarm items: nonfarm income and expenditures • Balancing section
Summary An income statement organizes and summarizes revenue and expenses for an accounting period. Net farm income, or profit, is a dollar amount, whereas profitability relates profits to the size of the business.