1.0 Introduction 2.0 Objectives 3.0 Main Content
3.1 Balance Sheet Analysis 3.2 Income Statement Analysis
3.2.1 Value of Production (VOP) or Total Value Product
(TVP)
3.2.2 Net Farm Income (NFI) 3.2.3 Gross Margin
4.0 Conclusion 5.0 Summary
6.0 Tutor-Marked Assignment 7.0 References/Further Reading
1.0 INTRODUCTION
Farm business analysis is the process of retrieving, organising, processing, and analysing information used in farm business decision making. It is a critical ingredient in the management of the modern farm.
Managers must be able to quickly respond to changes in the prices of the inputs and the products if they are to maintain farm profitability. The knowledge of farm business analysis is a necessity for all farm managers not only to maintain farm profitability but also to take advantage of opportunities of available credit facility.
2.0 OBJECTIVES
At the end of this unit, you should be able to:
define business analysis
explain balance sheet analysis
explain income statement analysis.
3.0 MAIN CONTENT 3.1 Balance Sheet Analysis
A review of the balance sheet provides insight into the financial health of the business. Comparison of balance sheets from a business through
time is a good indicator of performance of the business.
The analysis of balance sheet begins with a comparison of total assets
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and liabilities. The difference between total assets and liabilities is the net worth of the farm business. If total liabilities exceed total assets, the business is insolvent and net worth is negative. If on the other hand the total asset is greater than total liabilities, the farm business is solvent and
the networth or owners equity is positive.
The net worth of a business on a given date indicates owner equity and is a major factor that financial institutions consider before granting loans because it is an indicator of risk involved in loan advancement. The extent to which a loan is secured depends on the magnitude of the networth. If networth is large relative to total assets in the business, it signifies good security for the loan and the chance of loss is small. A smaller net worth may present an obstacle to securing credit because risk of loss to the lender is greater.
Comparison of current assets and current liabilities of a farm is an indicator of the liquidity of the farm. This implies that the farm has ability to meet cash obligations as they become due.
A farm with a balance sheet in a healthy financial condition will have current assets exceeding current liabilities. Typically, that excess should be one-and-one-half to twice as much in current assets as in current liabilities. The excess is needed for the following reasons:
1. It serves as a financial cushion in case of rapid change in prices of the components of the current assets. A rapid fall in price will reduce the liquidity of a farm business that has barely enough current assets to cover current liabilities.
2. Excess of current assets over current liabilities is a necessary indicator of financial healthiness of a farm business because the excess is a source of working capital for the business. Working capital is the source of funds for the current operating expense - items that must be purchased on a day-to-day schedule to keep the business operating. If there is a deficiency of working capital, the business must borrow additional funds or it must liquidate intermediate assets to secure working capital. The procurement of additional credit often takes time. If intermediate assets are liquidated, the assets that produce income for the business have been removed and future income flow will be reduced. Thus, asset liquidation is not a viable long-term alternative.
3.2 Income Statement Analysis
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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 labour, 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. The net farm income is discussed in detail below.
3.2.1 Value of Production (VOP) or Total Value Product (TVP)
This represents the values of all output of the farm. This amount represents the accrued value of commodities produced during the fiscal (or calendar) year.
Farm Cash Receipts + (Change in Value of Product Inventory + Change in Value of Accounts Receivable) - Livestock Purchases.
3.2.2 Net Farm Income (NFI)
Net farm income, (farm profit or loss based on operating earnings), is net cash operating income (farm receipts minus farm expenses) plus the adjustment for value of products consumed by the family, plus inventory adjustment, plus adjustments for accounts payable and receivable, and minus depreciation. This is not a ratio by definition, but it is included as it represents the bottom line for farms and a starting point for analysis.
The problem with net farm income is that it does not relate the income to the size of the investment. This is the advantage of using return on assets as a measure of profitability.
Net Farm Income (NFI) = Total Value of Production (TVP) - Direct Costs – Depreciation.
3.2.3 Gross Margin
This margin represents the excess of revenue or total value of production over the cost of variable inputs. Gross margin indicates funds available to cover unallocated fixed costs, returns to unpaid operator &
family labour, and returns to owner's / share holder's equity.
Gross Margin= Total Value of Production – Total Variable Cost (TVP – TVC)
4.0 CONCLUSION
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In this unit, we have analysed the balance sheet and profit and loss statement. The analysis of the balance sheet indicates the solvency, liquidity or otherwise of a business enterprise while the analysis of income statement indicates the profitability of the business enterprise.
5.0 SUMMARY
Balance sheet analysis shows the financial health of a farm business while the income statement reveals the profitability or otherwise of a business enterprise. Analysis of the balance sheet involves comparison of total assets and total liabilities. If the total asset is greater than total liability, the farm is solvent, if otherwise, it is insolvent. Gross margin, net farm income and value of production are derived from the income statement.
6.0 TUTOR-MARKED ASSIGNMENT
1. Discuss how you will ascertain the financial healthiness of a farm business.
2. State the importance excess of current liabilities over the current liabilities?
3. What is networth? Why is it so important to financial institutions?
4. Define or explain the following terms: (i) Gross margin (ii) Net farm income.
7.0 REFERENCES/FURTHER READING
A. J. Adegeye & Dittho (1998). Essential of Agricultural Economics.
Kay, Ronald D. (1981). Farm Management: Planning, Control and Implementation
ISBN 0-07-066366-1 McGraw-Hill Kogakusha, Ltd.
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