Determining the financial position of a farming operation
The Bank should always know what a client's financial position is and whether or not he/she is making progress. To this end, certain historical basic financial information and statements are required. Together with the projected cash-flow budget, the balance sheet and income statement form an integral part of your decision-making process.
By Deon van Wyk, ABSA Regional AgriBusiness Manager (email: firstname.lastname@example.org)
This discussion will however concentrate on the importance of the balance sheet.
The balance sheet originates from an inventory which indicates the starting point of a record or management information system. It details the physical numbers and monetary value of the farm's assets.
The balance sheet is a summary of the assets and liabilities of the farming business at a specific point in time. The liabilities shows the own capital and the loan capital of the business, as well as the conditions on which they were obtained. The assets show how this own capital and loan capital has been used. The capital position of the business can therefore be deduced from the balance sheet.
The balance sheet indicates the financial position of the business as at a specific date and gives a static picture of the business, as things may happen after that date to change the financial status.
It is a fairly simple statement that has an important role at farm-management as well as a credit-granting level.
Characteristics of a balance sheet
• A balance sheet reflects (a) the assets, (b) the liabilities and (c) the net value (a minus b) of a business as at a specific date.
• Assets are listed in order of their convertibility to cash (liquidity), that is to say, from land (the least liquid asset) to cash (the most liquid).
• The valuation of assets should be realistic and representative of current market values.
• The information in the balance sheet is normally recorded annually at the same point in time (date).
• Profits grow the assets of a business. Similarly, the net value should increase with profit, depending on personal withdrawals and other expenses.
• Liabilities (obligations) are listed in order of their repayment terms, that is to say, from liabilities over a long period to those payable within one year.
• A balance sheet may take several forms, depending on the type of business.
In the case of a one-person business, the balance sheet reflects the own capital of the owner, whereas it indicates the own capital of the partners in the case of a partnership. In the case of a company the own capital comprises of issued share capital, reserves and retained profits.
The next question is how sound is the business in the long term? How credit worthy and safe is the investment in the business?
• A balance sheet inter alia reflects the capacity of the business to service short-term financial commitments. The ratio of current assets to current liabilities indicates, inter alia, the liquidity position.
• The risk-bearing capacity of the business is reflected by it, that is to say, how seriously a specific financial loss will affect the liquidity of the business (e.g., is the client financially strong enough to survive a failed crop?).
• Essential information for estate planning is obtained from it (e.g. determination of assets).
• Year-end stocks necessary for calculating net farming income (NFI) is obtained.
• By comparing different balance sheets (the same month in previous years) with one another, trends in the assets, liabilities and net value can be discerned.
• From a financial point of view, a balance sheet is an important means of communication with the Bank.
Factors that cause wrong interpretation of a balance sheet
• Land is included in the balance sheet at its original purchase price. As land is such an important item, it should be re-evaluated every 3 years.
• Livestock is recorded at income-tax-values, which are considerably lower than current market prices.
• A balance sheet at the end of February does not always, particularly in the case of summer-crop farmers, give an accurate picture of the farmer's actual financial position, as the crop has not yet been harvested. In addition, his/her overdraft or production loan with the cooperative may be fairly large.
• As the Revenue Service permits a 100% write off over 3 years (50% – 30% – 20%) for purchases of mechanical equipment, the values of these items are not always reflected in the balance sheet. Clients sometimes tend not to disclose the value of movable assets. Always check this against the inventory.
• Farming requisites and farm produce on hand are often not shown as current assets in the balance sheet, or they are undervalued.
The balance sheet should always balance. The difference between the assets and the liabilities is the net value (owner's interest or own capital) of the business. It should represent a liability and is then that portion of the total assets that belongs to the owner or owner’s equity.
*First published in SA Forestry magazine, March 2019