By Paul Dietmann, Badgerland Financial
While the work on a farm never ends, most farmers have a stretch of “not-quite-so-busy” time between fall harvest and spring planting when things ease up a bit. This is a great point to assess your farm’s financial performance in 2013 and start the business planning process for 2014. Below is a list of 10 items that you might want to do this winter to tune-up your farm business and have it running as smoothly as possible in 2014.
Estimate your 2013 taxes before the end of the year–By November, most of your operating expenses for 2013 should be known, and your income through the end of the year can be estimated. This is an excellent time to sit down with your tax advisor to get a sense of your tax situation for the year. By getting a handle on your taxes in November, you’ll still have plenty of time to do the next two tasks on the tune-up list: 1) make year-end capital purchase decisions; and 2) decide whether or not to prepay some of your 2014 operating expenses.
There are several things you can do to get the most out of your appointment with your tax advisor. First, pull together a good summary of income and expenses for the year. Second, gather records for any capital purchases or sales you made during the year. Finally, review your 2012 federal tax return so that you are ready to compare this year’s estimate to last year’s results.
Decide whether or not to make year-end capital purchases–With a good estimate of your 2013 tax liabilities, you will be in a much better position to decide whether buying a new piece of equipment before the end of the year makes sense from a tax standpoint. However, tax management should not drive your capital investment decisions. You first need to determine whether the asset is really necessary and if you can afford the purchase. You also need to decide how much cash to use for a down payment and how much of the purchase should be financed. (To learn more about making capital investment decisions, see the chapter on investment analysis in the book Fearless Farm Finances: Farm Financial Management Demystified).
If you decide to go ahead with a capital purchase this winter, you can ask your tax advisor to help you figure out whether to make it in 2013 or hold off until after the first of the year. Changes in state or federal tax rules may influence your decision. For example, the Wisconsin Dairy and Livestock Investment Tax Credit is ending on Dec. 31, 2013. So if you live in Wisconsin and are buying dairy or livestock buildings or equipment, you might want to pay for those improvements before the end of the year.
Consider prepaying some of your 2014 operating expenses–There can be some big advantages to prepaying operating expenses before the end of the year. First, many suppliers offer big discounts for early purchases. Second, prepaid expenses will show up as a “current asset” on your balance sheet, which means the prepayment won’t hurt your working capital position (more on this below). Finally, the prepayment can reduce your income tax liability in 2013 if your estimates show that you are going to owe income taxes. However, if your farm is showing a loss for 2013, you might not want to prepay expenses because it could increase your tax liability in 2014.
Evaluate your risk management strategies– Obviously, farming can be a risky business. While it’s impossible to eliminate every risk, some of the most critical risks can be reduced. Make sure that your farm insurance coverage is sufficient to cover any losses that your farm business can’t absorb. If you haven’t been carrying health insurance because you felt it was unaffordable, now would be a good time to take another look at your options. The health insurance market has recently undergone significant changes.
Do you have life and disability insurance? Even a minimal amount of coverage will protect your family in the event of a tragedy. Are your crops or livestock insurable? If not, you may be able to reduce weather risks to your crops with irrigation or season extension strategies. You may reduce livestock production risks by contracting feed purchases or livestock sales.
Update your balance sheet on January 1–One of the most important things you can do to accurately assess your farm’s financial performance is update your balance sheet as of January 1 every year. Preparing the balance sheet on January 1 eliminates much of the seasoal variation in crop inventories. It allows you to make an accurate comparison between the most recent year’s balance sheet and prior years. It also lets you make “accrual adjustments” to your farm’s income statement for changes in inventories, prepaid expenses, and other changes that occurred between one year’s balance sheet and the next. The ability to make these accrual adjustments will give you a more precise calculation of net farm income and profitability.
A couple of things to keep in mind as you update your balance sheet. First, take a good physical inventory of stored crops, feed, market livestock, and supplies. Second, try not to make changes to market values from one year’s balance sheet to the next. The goal is to measure changes in inventories, not changes in market prices. Finally, be sure that any new equipment purchased during the year gets added to the balance sheet, and any equipment sold gets taken off.
Calculate a few simple financial measures– With your estimated taxes and an updated balance sheet, you’ll be able to calculate a few useful ratios that measure your farm’s financial health.
Working capital–Subtracting current liabilities from current assets will give you “working capital.” Working capital should be at least 15% of your annual gross farm income.
Current ratio–Dividing current assets by current liabilities will give you “current ratio.” The current ratio should be two or more.
Debt-to-asset ratio–Divide total liabilities by total assets to get your “debt-to-asset ratio.” Your debt-to-asset ratio should be less than 50%, although it will typically be higher than 50% if you’ve recently purchased or significantly expanded your farm operation.
Rate of return on assets–Take your estimated net farm income, add back the farm interest that was paid during the year, and divide the resulting number by the total assets on your balance sheet to get your “rate of return on assets.” The rate of return on assets should be higher than the interest rate you are paying on farm loans.
Operating expense ratio–Dividing your total farm operating expenses (excluding interest payments and depreciation) by gross farm income will give you “operating expense ratio.” In general, the operating expense ratio should be less than 75%, but it can vary depending on the type of farm enterprise. More important with farm expense ratio is that it not swing more than 5% from year to year. If it does vary by more than 5% from one year to the next, dig a little deeper into your financial statements to find out why.
Establish or evaluate a revolving line-of-credit–If, at certain times of the year, you find yourself putting farm expenses on credit cards or having to decide between paying the feed bill or paying the utility bill, it would be a good idea to establish a revolving line-of-credit (RLOC) for the farm. It typically doesn’t cost anything to establish a RLOC. The interest rate on a RLOC will be much lower than credit card interest rates. And, interest only accrues when you are carrying a principal balance. Using a RLOC is a good way to maintain the farm during months when cash flow is short.
If you already have a RLOC, this is a good time to review it with your lender. Is your credit limit appropriate for your needs? Are you only using the line for operating expenses, or have you been using it to make capital purchases that should really be set up on a term loan? Have you been able to pay the principal balance on your RLOC down to zero at least one month each year?
Develop 2014 enterprise budgets–Winter is a great time to put together enterprise budgets with income and expense estimates for the major operations you plan to have in 2014. Your budgets can be set up in whatever manner best fits your farm: per acre; per head; or per marketing outlet. Your enterprise budgets can help you decide where you can most effectively invest your time, effort and money in 2014.
Prepare a 2014 cash flow projection–When you’ve completed your enterprise budgets, and made your production and marketing plans for the upcoming year, the next step is to map out all of your estimated cash inflows and outflows on a month-by-month basis through 2014. The purpose of the month-by-month cash flow is to predict the months when cash shortages are going to occur. It will allow you to develop a plan ahead of time to get through the lean months. You may want to increase your working capital reserve during months with strong cash flow rather than paying off principal on longer-term loans. You may choose to establish a RLOC. You might shift enterprises to even out cash flow. Or, you may want to generate more cash inflow from custom work or an off-farm job.
Check over your retirement plan, will, and other long-range planning documents–Many farmers consider their farms to be their retirement plans. They either don’t ever intend to retire from farming, or plan to rent the farm out at some point to generate retirement income. Unfortunately, life events don’t usually follow the plan. Illness or injury could make it impossible to continue farming. Cash rental rates might not provide an adequate income to cover family living costs in retirement. Perhaps you have a child who farms with you and other children who don’t. You want your assets to be divided fairly among all of your children after you are gone. Investing some funds in an off-farm retirement plan can help under any of these circumstances.
Do you have a will and other related estate-planning documents? It is easy to procrastinate when it comes to estate planning. If you already have an estate plan in place, review it to make sure that it still meets your intentions. If you don’t have a plan, put it on your to-do list this winter.
Don’t feel as though you need to complete this whole list at once. Start with your tax planning in November. Make decisions about capital purchases and prepayment of expenses in December. Take your feed, crop and supply inventories in early January. Complete your balance sheet after you receive your year-end bank statements. Once your balance sheet is done, you can calculate the financial ratios. Everything else can be done in February or March.
Accomplishing these 10 tasks will help you see how your farm business has performed over the past year, and get it tuned up and ready to roar in the years ahead.
Paul Dietmann is the Emerging Markets Specialist at Badgerland Financial, and a co-author of the MOSES book Fearless Farm Finances.
Get help with your farm’s numbers at this two-day training Dec. 6-7 in East Troy, Wis. – scholarships available! Click here for more information.