Knowing how to read and understand financial statements is one of the first steps in assessing financial risk, helping you track how you’re doing compared to previous years (or against sector averages), and how any changes may have an impact on your bank account.
From a financial perspective, stress testing can be the ultimate proactive risk management tool.
Mark Fournier, an instructor at Olds College in Alberta and a certified chartered accountant, emphasizes the importance of understanding cash flows in his farm finance and business planning courses.
“While paper profits are nice, cash is king,” Fournier says. “And if there is no money in the account, then the farm family does not get to eat or to pay their mortgage.”
Fournier starts his courses by teaching students how to read farm financial statements, including balance sheets, income statements and cash flow statements. Then, mostly using ratios, he has the students test a farm’s financial health by comparing the information from the current full accounting year with both the farm’s own historical statements and with industry benchmarks.
They learn that a balance sheet is a snapshot of a company’s assets, liabilities and owners’ equity. An income statement is done on an accrual basis for a full accounting year. And the cash flow statement is done on actual receipt and payment of cash for a particular accounting time frame, nailing down the liquidity of the business during that time period.
What Fournier likes about cash flow statements and projections is that bank accounts don’t lie.
“Unlike profits — which include non-cash items like depreciation, accounting gains and losses — the bank account will dictate if you are going to have a good month or a challenging month,” says Fournier.
So once the Olds students finish the historical analysis, Fournier teaches them how to prepare a 12- to 36-month cash flow statement that can be updated on a monthly basis. They complete a cash flow in FCC’s Ag Expert, although most of the real-life work is done in Excel or Google Sheets so they can create templates to use on their own farms.
They estimate and input the cash inflows on a month-by-month basis, and estimate monthly cash outflows. All this is done to get to the ending bank balance each month.
This is a reality check since a negative balance means that the farm owner will either have to inject personal money, or a new loan will need to be taken out.
Instead of doing a month-to-month cash flow statement, annual cash flow statements of a farm’s operations can be calculated by subtracting the cash expenses from cash income, as taken from the farm’s income tax statement.
To do this you have to remove the mandatory and optional inventory adjustments, and the capital cost allowance amounts from the cash expense amount on the income tax statement.
However, monthly cash flow statements also consider other factors and should include the effects of operating, financing, investing and personal activities on cash over a previous fiscal period. This way, they reveal the hard bank account truth. They’re also an easier way into potentially more useful cash flow projections.
Fournier finds the most overlooked component of farm cash flow statements and projections is taking out a salary for the owner.
“People tend to try to pay themselves with any money that is left over,” he says. “But the farm owner needs to put food on the table and gas in the personal vehicles, so include all living costs in the planning.”
Saskatchewan’s Ministry of Agriculture publication Comprehensive Guide to Farm Financial Management, Preparing Cash Flow Statements not only has a fill-in-the blank cash flow statement form that might be helpful, there’s also an itemized form to help determine family living expenses based on the previous year.
Keep in mind that a cash flow projection summarizes an estimate of cash in and out over a given future period, but is only as good as the assumptions and information used to prepare it.
Also note that depreciation does not appear on the cash flow projection because it’s not a cash expense and will not have an impact on cash flow.
Basically cash flow projections show how your farm and family plans for the future have an impact on the amount and timing of cash received and spent.
Often cash flow projections are used to test the feasibility of new investments or a transition. These spreadsheets are used to test scenarios to see the impact of different prices, costs and even time and terms. A cash flow projection can also be used to see if operating lines of credit will meet needs and should help identify potential times of excess cash.
One of the main functions required in reviewing financial statements for management purposes is calculating what the operating loan requirements will be for the farming operation in the upcoming year. Traditionally farms need operating funds at certain points during their business cycle, such as before harvest when they’re carrying all their input expenses and haven’t got crop delivered.
By doing a monthly assessment of cash flow requirements, you can pinpoint the months with the largest shortfall amounts and the months with the largest surplus amounts.
Whether it’s in the classroom or in his former job working in farm credit, Fournier has found farmers relate to cash flow statements. Often, instead of looking at their balance sheet or income statements, farmers prefer to dig directly into cash flow statements, breaking it down on a month-by-month basis.
And then they can quickly move into planning mode. After inputting the cash inflows and outflows based on the previous year’s cash flow statement, they can estimate the projected farm bank balance at the end of the month for the coming year.
Then the fun begins as the farm can incorporate this information into its cash flow projection spreadsheet to see the cash implications and adjust either loan amounts, or operational activities accordingly.
“The farm business owner can apply their story or plan, and relate to real numbers,” says Fournier. “Almost all future planning work is completed using cash flow projections.”
Once the cash flow projections are completed, says Fournier, then it’s relatively easy to create an income statement and balance sheet directly from the cash flow spreadsheet.