AgDM newsletter article, February 1997
A farmer recently told me that 1996 was a profitable year for him. He knew he had done well because it was the end of the year and he had a lot of money left in his checking account. The checking account approach is one of the traditional methods used by farmers to measure profitability. But is it a good way?
Problems with this method
There are a number of problems with the checking account approach. One problem is that only cash (one asset) is considered. The amount of cash is usually small when compared to the value of grain and livestock inventories, farm machinery, land and buildings. Also, the amount of cash constantly changes, often by large amounts. Astute farmers often try to keep the amount of cash reserves fairly small by investing excess amounts in liquid non farm financial assets or farm assets.
Another problem with the checking account approach is that commodity sales during the year may have reduced the year-end inventory of crops and livestock below normal levels. So a large cash balance may be due to large inventory sales rather than high profits. This approach also doesn’t show depreciation of farm machinery and buildings.The income statement method
Farm profitability is best measured with a farm income statement. Believe it or not, income statements are fairly easy to prepare.
First you compute gross farm revenue. This is the sum of cash farm income, income adjustments such as changes in crop and livestock inventories during the year, and the value of home-raised production.
Next you compute farm expenses. This is the sum of cash farm expenses, expense adjustment such as prepaid expenses and accrued interest, and depreciation.
Subtracting expenses from revenue gives you net farm income from operations. This figure, plus capital gains or losses from the sale of farm capital assets such as breeding livestock and farm machinery, gives you net farm income.What good is the income statement?
You can also calculate financial performance measures by using information from the income statement and two consecutive years of net worth statements. These measures help you assess the profitability, debt carrying capacity, and financial risk you currently face. Comparing performance measure figures over time and with similar operations gives you an idea of how your operation is doing.
How to prepare income
While preparing a farm income statement may appear difficult, helpful information is provided in the Decision Files. These can help you create and interpret a farm income statement.
Information is also available on preparing and interpreting cash flow and net worth statements. After you have developed these statements, you can compare yourself to other farmers by using the following Decision Files:
Although it requires some extra time, preparing an income statement provides valuable information about your farm operation. This information can be used to increase profits in future years. If you have trouble interpreting some of the numbers, your lender or extension farm management specialist can help.