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Income Statement Analysis

Analysis of the income statement involves reviewing several variables available or easily calculated from that document.

Net farm income is the "bottom line" on the income statement and a good place to begin the analysis procedure. This figure represents return to unpaid operator and family labor, equity capital, and management. Over the long-term, net farm income is the amount available for discretionary use by the family and for business development. If a withdrawal for family living is made in computing net farm income, then net farm income represents the amount available for business expansion and risk-taking. When family withdrawals are not deducted in computing net farm income, the expenditures for family living have a priority claim on part of the amount reflected in net farm income.

Interpretation of net farm income requires good judgment on the part of the evaluator. More is generally better, but evaluation of the level of net farm income from a particular farm must be completed with a view to type and size of operation. A $7,500 net farm income from a 60-cow beef herd might reflect an excellent return. But that level of net farm income from a 60-cow dairy herd is unacceptable, based on recent rates of return for successful dairy operations. Thus, it is necessary to have standards for comparison in evaluating net farm income.

The standards needed in evaluating net farm income are available for some farm types and enterprises, but not available for others. In Pennsylvania, very good information is available about dairy farms; other farm types are more difficult to evaluate. Regional differences do exist and the evaluator should be careful that the standard being used is the appropriate one for the location of the farm under consideration.

The operating ratio is another variable that can be used to evaluate net farm income. The operating ratio is total operating expense (cash farm expense) divided by gross income. The ratio converted to a percentage reflects the part of gross income that is required to cover farm operating expense.

The difference between the quantity "100" and the operating ratio as a percentage is the operating margin. For example, if the operating ratio as a percentage is 70, the operating margin is 30 (100-70). This margin represents the share of income that is available to cover family living, business fixed obligations, and business expansion. Generally, the operating ratio (or percentage) should be less than .75 (or 75 percent) which results in an operating margin of 25 percent or more.

Rate of return on total capital is a third analysis variable computed by making minor adjustments to net farm income from the income statement. Rate of return on capital is net farm income plus interest paid as a farm operating expense, minus an allowance for operator labor, with the total divided by average capital investment. (Remember that net farm income is the return to unpaid family and operator labor, equity capital, and management).

Example: A farm's income statement shows net farm income of $30,000, interest paid of $14,000, and an allowance for unpaid operator labor of $12,000. Total capital investment for the farm is $340,000. Rate of return to total capital is:

($30,000 + $14,000 - $12,000) / $340,000 = 9.41%

The value computed for rate of return to total capital can be compared to rates of return for stocks, bonds, or other nonfarm securities. However, that is a valid comparison only if the farm operator is willing to liquidate the business and apply the funds in the nonfarm investment. Historically, capital invested in farming has not yielded as much return as capital invested in nonfarm securities. A more valid comparison for a continuing farm business is one made with other similar farms in the area or with the long-term rate of return to agricultural assets. The latter rate has averaged about 6 percent for a number of decades. (The reader should be aware that this low rate of return to farm investment has been compensated to some degree by appreciation in land value. Unfortunately, this gain can be realized only if the farm business is liquidated.)

Comparisons with other similar farm units must be approached with a cautious attitude. It is essential that the units selected for comparison are those with similar crop and livestock programs, using similar technology, and located in similar climatic and soil areas.

Figure 2 is a typical farm income statement. Cash farm receipts are itemized on the left side. An adjustment is made in the receipts section for accounts receivable. The sum of cash farm receipts and the adjustment for accounts receivable is gross farm income. Cash farm expenses are itemized on the right side of the form with an adjustment for accounts payable included.

Depreciation is added to cash farm expenses to arrive at total farm expenses. That amount is deducted from gross farm income to arrive at net farm income.