Cash flow vs. profitability
Improving Your Farm Profitability: #2
by Craig Chase, program manager
I often hear beginning farmers talk about how their farm is profitable. When asked how they know, they often answer that they had more money at the end of the year than at the beginning. Having more money in your bank account is a good thing. But what more money really indicates is that the farm had a positive cash flow. Cash flow and profitability are not the same thing.
Profitability indicates you had an economic return to the labor, capital (machinery and buildings), and land you provided to the business. If you didn’t pay yourself for the labor, capital, and land provided, you don’t know if the farm business is profitable or not.
A positive cash flow indicates that the amount of cash flowing into your farming operation was greater than the cash flow out. However, you don’t know if the positive cash flow was a result of your farming operations or was from other sources (e.g., loans, sales of equipment, etc.).
Telling the difference
How can you determine if your farm is both profitable and has a positive cash flow? You need to develop an income statement and a statement of cash flows.
The income statement can be adjusted from your IRS Schedule F tax form. You’ll need to adjust the Schedule F somewhat, because it typically reflects calendar year activities and is based on cash income and expenses.
For example, what happens to the sales you made in January that were produced the previous year? Or the sales in December you haven’t received the cash for?
You may also have paid expenses in December for next year’s production. All these types of cash transactions should be adjusted so the expenses and the revenue match up to the same production year. These adjustments are called accrual adjustments. They can have a large impact on what your income was for any particular year.
- add an amount for the labor you contributed
- pay yourself cash rent for the land you provide, and
- pay yourself a machinery rental rate for the equipment you contribute
These adjustments will determine the true economic profitability of your farming business. If your farm is no longer profitable after these adjustments, determine why. If you can’t pay yourself, how will you be able to hire any labor? If you can’t pay for the equipment you provide, how will you be able to replace it when it wears out? If you can’t afford to pay rent, how will you ever be able to increase your land base?
If you don’t have separate bank accounts for the different aspects of your farming business, you may have trouble figuring out why you had more money at the end of the year. Did you sell any equipment, take out a loan for next year’s production, or deposit off-farm cash in your farm cash account?
You should develop a statement of cash flows which divvies up the various cash transactions between farming operations, capital (primarily machinery) sales and purchases, and financing activities (primarily loans). Make sure off-farm cash does not get commingled with the farm cash.
Is the cash flow from your farm operation positive after taking all this into account? If so, congratulations! That is a good indicator of sustainability. If cash flow is negative, determine why. If it is negative because you made a large equipment or land purchase and used cash from operations, perhaps you should take out a loan. If you had good production and are still short of cash, should you increase your prices? You also could develop enterprise budgets for products you believe contribute the most toward your cash flow. (See some resources listed below.)
The key to a sustainable business is to be both profitable and have a positive cash flow. One without the other may allow your business to go on for a while, but eventually you’ll need to make major adjustments. It is better to know as soon as possible if things are not working as planned. Then you can more easily make small adjustments to correct any problem.
Questions? Contact me.