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Group Title: Economic information
Title: The essential financial tools for running a firm
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Full Citation
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Permanent Link: http://ufdc.ufl.edu/UF00026498/00001
 Material Information
Title: The essential financial tools for running a firm
Series Title: Economic information report - University of Florida. Food and Resource Economics Dept. ; 97-8
Physical Description: 23 p. : ill. ; 28 cm.
Language: English
Creator: Van Blokland, P. J.
University of Florida -- Food and Resource Economics Dept
Publisher: University of Florida, Institute of Food and Agricultural Sciences, Food and Resource Economics Dept., Florida Cooperative Extension Service
Place of Publication: Gainesville Fla.
Publication Date: 1997
Copyright Date: 1997
 Subjects
Subject: Agriculture -- Finance   ( lcsh )
Small business -- Finance   ( lcsh )
Agriculture -- Economic aspects   ( lcsh )
Genre: non-fiction   ( marcgt )
 Notes
Statement of Responsibility: P.J. van Blokland.
General Note: Cover title.
General Note: "December 1997."
 Record Information
Bibliographic ID: UF00026498
Volume ID: VID00001
Source Institution: University of Florida
Holding Location: University of Florida
Rights Management: All rights reserved by the source institution and holding location.
Resource Identifier: notis - ALR7835
alephbibnum - 002314405
oclc - 38207940

Table of Contents
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        Front Cover
    Abstract
        Abstract
    Main
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Full Text



P. J. van Blokland Economic Information
Report 97-8







The Essential Financial Tools
For Running A Firm



















T UNIVERSITY OF
SDOC LORIDA
100
od and Agricultural Sciences
F637fe ource Economics Department
El operativee Extension Service D e 1997
97-8 nesville, FL 32611












THE ESSENTIAL FINANCIAL TOOLS FOR RUNNING A FIRM

P.J. van Blokland, Professor in Agricultural Finance, University of Florida




ABSTRACT

The paper is intended to provide the owner of an agricultural firm with the essential
financial tools for running the business. Each tool is outlined and illustrated with an
example. The paper starts with the historical tools, which include the firm's objectives,
balance sheet and income statement and follows with the tools necessary to analyse
these statements. These analytical tools examine the liquidity, solvency, profitability,
efficiency and repayment capacity of the firm. The results of this analysis are used to
re-examine the firm's objectives. The paper then employs the historical performance
and the objectives to map out the future of the firm. The maps include enterprise and
firm budgets and the cash flow budget. The results are compared with the firm's
objectives which may be altered again as the budgeting results appear.



KEY WORDS

Objectives, financial statements, liquidity, solvency, profitability, efficiency, repayment
capacity, enterprise, firm and cash flow budgeting.



OBJECTIVE

The objective of this paper is to present a description and a succinct discussion of the
financial tools needed by an owner of an agricultural firm to assist in making sensible
financial decisions. The owner and the manager are assumed to be the same person.
Each tool is outlined sufficiently to follow the major points in using the tool.








U~ ^Si y OF F, (' ~ r[ M s









THE ESSENTIAL FINANCIAL TOOLS FOR RUNNING A FIRM



INTRODUCTION

Management in any job is basically using information to make decisions to help the
firm meet its objectives. Objectives must be written down and quantified in terms of
numbers and time. "Make a profit" is not an objective. "Make $100,000 net income by
the end of December three years hence" is. The manager needs to know where the firm
stands today and how it got there. Therefore a lot of good management consists of
linking the past with the future by making sound decisions today. This paper will
present some of the main financial tools that do this linking. These tools are outlined in
Diagram 1.


The tools provide the information necessary to make most of the production, marketing
and financing decisions in the firm. The diagram starts with the information that the
manager thinks he needs. This information is digested and used to write the firm's
objectives. The diagram then separates into two parts. The left hand side, or the
recording section, shows what has happened to the firm over time. These events were
recorded and analysed to write the objectives of the firm. The right hand side, or the
management section, shows what might happen to the firm if it meets its current and
future objectives. The left and right hand sides are linked by monitoring. In other
words, by comparing what actually happened with what the manager thought would
happen. He must make decisions on any differences between the two. There will, of
course, always be a difference for no one is clairvoyant. The real job is to take
appropriate action on this difference.

For instance, suppose that the manager thought, based on historical performance, that
his second quarter cash sales margin over cash costs would be $400,000, and the
margin actually was $300,000. He is $100,000 short and had probably committed that
$100,000 to future uses. He may have lined up resources for that purpose and now has
bills to pay. He has to find out why there was a cash margin difference of 25% and
what he should do about it (doing nothing is still a decision). This is not easy but it is
real management. These tools will help in this decision making process and, if
necessary, help modify future objectives.







1










DIAGRAM 1. THE ESSENTIAL FINANCIAL TOOLS OF A FIRM

INFORMATION .
SELECTING, RECORDING AND USING INFORMATION
TO SET OBJECTIVES AND ACHIEVE THEM
WHAT DID HAPPEN WHAT MIGHT HAPPEN
(PAST) i.e. Recording (FUTURE) i.e. Management

BALANCE SHEETS ENTERPRISE BUDGETING

INCOME STATEMENTS FIRM BUDGETING

EQUITY STATEMENTS CASH FLOWS
PROFORMAS

ANALYSIS

LIQUIDITY SOLVENCY PROFITABILITY EFFICIENCY COVERAGE
DECISIONS
MEETING OBJECTIVES

THE BALANCE SHEET

The balance sheet presents a picture of the firm at one point in time. This is important
to digest. Because the balance sheet is a snapshot of the firm on a single day, the firm's
owners, sensibly and legally, make this statement look as good as they can to impress
their readers. People dress well when they are interviewed or inspected. Firm owners
do the same thing when they produce their balance sheet.

The balance sheet shows three things: assets, liabilities and equity or net worth. Assets
are what the firm has. These possessions are usually divided into three categories in
agriculture: current, intermediate and long term. Current assets are assets that can be or
soon will be turned into cash. They include items like inventory for sale, supply
inventory, cash, cash equivalents (e.g. savings accounts, stocks, bonds, mutual funds)
and receivables. Intermediate assets usually consist of vehicles, equipment, machinery,
breeding stock, plants and trees between one and seven years old, and non permanent
buildings and structures. Long term assets typically are plants and trees over seven
years old, permanent buildings and land.

Liabilities are what the firm owes. These also have three categories. Short term
liabilities are what the firm owes in the period between the most recent and the next
balance sheet. This period is every three months for firms with quarterly statements and

2









every twelve months for firms with annual statements. Current liabilities list bills which
must be paid in the next three months for quarterly reports or bills that must be paid
over the next year for firms with annual reports. Current liabilities include the principal
and interest on operating loans, payables and the current principal and interest portion
of intermediate and long term debt., i.e what the firm owes in the next period on its
notes and mortgages. Intermediate liabilities are what the firm owes on notes after
deducting the current portion of the debt. Likewise long term liabilities are the
remaining mortgages owed after meeting the current portion.

Equity is what the firm owns. It is calculated by subtracting all the liabilities from the
firm's assets. Consequently it is a residual and is found by subtraction. For example, if
assets are $2.5 million and liabilities are $1.5 million, the firm's equity is $1 million.
Equity is a key number for managerial scrutiny. Owners want to see steady equity
growth, period after period. Equity is used in various ratios to see how the firm handles
debt. For example, leverage ratio is defined as total debt divided by equity. In the
above instance, the ratio is $1.5 million divided by $1 million, or 1.5. This means the
firm owns $1 for every $1.5 of debt. If the ratio increases, there is more debt owed per
dollar owned and its risk has increased. If the ratio falls, the firm has reduced its risk.

The balance sheet can be used to compare how the categories or any or all of the assets
and liabilities have changed from one period to the next, and the effect of these changes
on the firm's equity. The balance sheet is illustrated in Diagram 2.

DIAGRAM 2. A SIMPLE BALANCE SHEET

ASSETS LIABILITIES + EQUITY

Current Current
cash + cash equivalents payables
sale inventory operating loans
supply inventory current portion of notes
other inventory current portion of mortgages
receivables other loans
Intermediate Intermediate
vehicles vehicle notes
equipment equipment notes
temporary buildings building notes
Long term Long term
permanent buildings building mortgages
land land mortgages
Equity

TOTAL TOTAL

3









THE INCOME STATEMENT

The income statement shows how the firm performed in the period between the two
balance sheets, i.e., during the quarter or during the year. The income statement shows
three things. These are outputs, costs and incomes, each with its own section. The
income statement is perhaps the most important statement to analyse in a firm. It shows
how the manager used resources and what he got from their use. This analysis can often
separate good managers from "other" managers, by showing the returns they received
from their resource investments.

The first section of the income statement shows gross output. Gross output is what the
firm produced. It includes sales, the change in the supply and for sale inventory from
one balance sheet to the next, other firm income and change in receivables. Gross
output should increase over time and the proportion of sales making up gross output
should be consistently high. This is because gross output can increase in one period
with inventory sales, but this inventory must be replaced later on.


The second section of the income statement shows costs. Costs are divided into three
main groups. The most important group is cash costs, which often make up 75% of any
agricultural firm's total costs. Cash costs are defined as items paid with cash. These
include supplies, labour, interest, fuel, repairs, insurance, rents and marketing
expenses. Cash costs are usually divided into four or five major categories for analysis.
For example, some firms may find the following categories useful: 1. chemicals and
fertilisers; 2. labour, social security and associated taxes and expenses; 3. marketing
expenses; 4. interest (see Diagram 3). The categories will probably vary with the firm.
There is no standard. The concept is to try to account for at least 80% of the firm's
cash costs in these categories in order to track each category over time.

Gross output minus cash costs equals gross margin. Gross margin shows whether the
firm can cover its cash costs and, if it can, how much is left to cover the rest of its
commitments. Gross margin can be used for tracking individual enterprises and the
whole firm. It is useful to follow the trends in gross margin of the different enterprises
and use this information to make changes in enterprise operation.

The second cost group is depreciation. This cost is essentially the annual rate allowed
by the IRS to write off depreciable capital assets. Depreciation is a real cost though it is
not paid by the firm until it replaces its capital assets. The capital assets that can be
depreciated include machinery, vehicles and buildings as well as breeding stock and
orchards after they start producing. Consequently, until these assets are replaced, the
depreciation allowances by the IRS add cash to the firm. This "additional" cash is most
easily seen in the cash flow.


4









The third cost group is overhead. This group is usually disregarded by firms or used as
a catch all for miscellaneous items. All overhead items can be put in either cash or
depreciation costs. But because overhead is relatively unproductive compared with the
other two cost groups, overhead should be recorded separately. Overhead items include
all office expenses, business education and publications, lawyer and accountant fees,
business travel and client entertainment. There is a tendency for firms to expand their
overhead in good years when that money might be better spent on cash cost items.
Therefore it is advisable to track the percentage shares of the three cost groups over
time to see where the firm's expenditures go. For example, a "typical" full time Florida
farm firm today might have 75% of its costs as cash, 18% as depreciation and the
remaining 7% as overhead. Any marked deviation from the firm's historical trends
needs investigation and explanation.

Cash plus depreciation plus overhead costs equals total costs. Gross output minus total
costs equals net firm income. A positive net firm income shows the firm has covered all
its costs. But net firm income is not profit. The firm still has other commitments. Net
firm income is essentially equivalent to taxable income for a non-corporation because
property taxes, road taxes and other firm taxes are included in cash costs. A high net
firm income means higher income taxes, which might encourage the manager to
purchase some needed depreciable capital asset. Depreciation reduces the net firm
income and consequently the tax bill.

Net firm income minus the owners' income and social security taxes provides net
income. This is the bottom line of any firm. To see how a firm is doing, follow its net
income over time. A firm's net income can only be used for three things. These are the
owners' salaries, re-investing in the firm and principal payments. Owners' salaries
means what the owners withdraw for their living expenses including vacations,
purchases for private items, education, etc. Owners' salaries are the corporate
equivalent of dividends. Any firm capital purchases must also come from net income.
These purchases are the same as re-investing in the firm. Finally, principal payments
are settled with the firm's net income. The corporate equivalent of principal plus
investments is called retained earnings.

The income statement is illustrated in Diagram 3.











5











DIAGRAM 3. AN INCOME STATEMENT

GROSS OUTPUT
sales
other income to firm
change in supply inventory
change in sales inventory
change in receivables
TOTAL

CASH COSTS
category 1. e.g. chemicals and fertilisers
category 2. e.g. all hired labour expenses
category 3. e.g. transportation, fuel, repairs
category 4. e.g. all marketing expenses
category 5. e.g. all other cash costs
TOTAL

GROSS OUTPUT CASH COSTS = GROSS MARGIN

DEPRECIATION
vehicles
machinery and equipment
buildings
all other depreciable assets
TOTAL

OVERHEAD
office expenses
salaries and fees
business travel
entertainment
all other overhead
TOTAL

TOTAL COSTS
cash
depreciation
overhead
TOTAL

GROSS OUTPUT TOTAL COSTS = NET FIRM INCOME

OWNERS' TAXES
income taxes
social security taxes
other taxes
TOTAL

NET FIRM INCOME OWNERS' TAXES = NET INCOME

NET INCOME
principal payments
re-investing
owners' salaries



6









The income statement shows the money coming into the firm and where the money
goes in the firm in the period between the two balance sheets. The cost framework in
the statement can be adapted by any firm to suit its specific needs. The items listed
under each cost are examples only. The net income shows how the remaining money
was spent after paying total costs and owners' income taxes. Put another way, net
income minus investing in the firm and principal payments equals what the owners
withdrew as salary.

Typically, analysing this statement will include trends in gross output, cost groups and
categories of cash costs, incomes and the changes in the components of each that caused
these trends. Decisions will be made on these changes and objectives re-written as
cause and effect are determined.

THE STATEMENT OF OWNER EQUITY

The statement of owner equity links the period between the beginning and ending
balance sheets with the income statement to show how owner equity has changed over
time. Diagram 4 shows the linkages for a quarterly set of statements. Owner equity is a
key number to monitor. It shows how much of the firm belongs to the owners. Equity
growth probably ranks second to net income as the most important firm indicator of
success.

DIAGRAM 4. STATEMENT OF OWNER EQUITY

BEGINNING BALANCE SHEET ENDING BALANCE SHEET
DECEMBER 31 MARCH 31

INCOME STATEMENT
JANUARY 1 TO MARCH 31

STATEMENT OF OWNER EQUITY
JANUARY 1 TO MARCH 31

This statement has three useful pieces of information. It shows firstly how equity is
increased by paying off principal and investing in the firm (adding retained earnings in
accounting language). Secondly, it shows how equity is depleted by taking salary from
the firm. And thirdly, it shows how inflation and deflation affect equity as asset values
change. The following example illustrates these functions.

The statement starts with the equity recorded in the beginning balance sheet, say on
December 31. Assume equity on this date is $500,000. The net income from the
income statement for the next quarter, i.e., January 1 to March 31, is added to this
equity. With a net income of $50,000, equity increases to $550,000. Subtract owners'

7









salaries of $20,000, and the revised equity is now $550,000 $20,000, or $530,000. So
firm equity increased during the quarter by $30,000. This increase resulted from paying
off principal and re-investing. (Note that the $50,000 net income went on $20,000
salary and $30,000 principal and investing.)

The second function of the statement shows that equity was depleted $20,000 by
withdrawing $20,000 salary. Obviously, the more the owners withdraw the less the
equity growth will be. This may seem trite but it is an important point. Owners have to
have enough to live on and to enjoy themselves. Only they can decide whether the
increased enjoyment is worth the reduction of equity growth. This statement shows the
relative effects clearly. Some 40% of the quarter's net income went to salary, so the
remaining 60% was available to increase equity.

The third function of the statement shows the changes in asset valuation due to external
factors. These externals are usually combined under the rubric of inflation. It is
possible for a firm's equity growth to be entirely due to inflation. If, for example, land
prices double, the firm's real estate is worth twice as much as it was before and equity
growth is correspondingly impressive. And as inflation decreases and equity growth
correspondingly falls, the firm does not look so good. This artificial type of equity
growth must be realized to avoid bad decisions. In order to calculate asset valuation
changes correctly, the manager needs a balance sheet recording both book and market
value valuations of assets.

Book value can be measured in three ways, depending on type of asset. One measure is
what the owner has invested in the items. This measure will apply to most of the firm's
inventory items. For example, valuing a 10-inch plant at $4.50 because this is the sum
of the cash, depreciation and overhead costs and management that went in it. A
second way to measure book value is to use the recent purchase price of the item. This
measurement is often used for non depreciable assets. For example, valuing recently
bought land at the purchase price of $3,500 per acre. The third way to measure book
value is to use the current depreciated value of the asset. For example, a three year old
tractor that was originally purchased for $70,000 and is depreciated at $10,000 per
year, now has a book value of $40,000.

The market value of an asset is what the firm could get for that asset if it were sold in
the period between the two balance sheets. Market value is usually greater than book
value. Current assets are valued at either what has been invested in them (book value),
or what they could be sold for in the market place. Suppose the book value of these
assets is $90,000 and the market value is $120,000. There is a difference between the
two of $30,000. Suppose that the book value of the intermediate assets was $150,000
and their market value was $200,000, for a difference of $50,000. Likewise the book
value of the long term assets is $400,000 and the market value is $600,000, with a
difference of $200,000.

8









This last sentence needs elaboration. Land assets dominate the total assets of
agriculture. Land cannot be depreciated, so the "book" value of the land is either the
original purchase price or, if it were purchased generations ago, the latest assessment of
the value of the land. The market value is what the land can fetch in today's market. It
is usually land values that signal inflation in agricultural markets.

So the book value of all the firm's assets is $90,000 + $150,000 + $400,000 =
$640,000. The market value of its assets is $120,000 + $200,000 + $600,000 =
$920,000. The difference between the two is $280,000. Taxes will be due on the
differences in the non current assets if they are sold. With a tax bracket of 20%, the tax
due is [($600,000 + $200,000) ($150,000 + $400,000) x 0.20)] = $50,000.

Assume that all these asset values are shown in the beginning balance sheet. If liabilities
are $140,000, then the cost or book equity is $640,000 $140,000 = $500,000. The
book equity is the equity earned by the firm up to that point in time. The market value
equity is $920,000 $140,000 = $780,000. This equity is what the owners would get if
they sold all their assets and met all their pre-tax liabilities. Therefore the gain in equity
from the value difference alone is $670,000 $390,000 = $280,000. Subtract the tax of
$50,000 that would be due from selling these assets, = $230,000. This $230,000 is
what is called the valuation equity or the amount that equity has increased solely due to
increases in the value of the firm's assets.

Assume also that the ending balance sheet records a valuation equity of $260,000. The
gain in the quarter, from changes in asset valuation only, is $260,000 $230,000 =
$30,000. Diagram 5 summarizes the three functions of the statement of owner equity.

DIAGRAM 5. SUMMARY OF STATEMENT OF OWNER EQUITY

BOOK MARKET
Owner equity in beginning balance sheet 500,000 780,000

1. Net income during the quarter plus 50,000 50,000

2. Salary taken during quarter minus (20,000) (20,000)

3. Change in valuation equity
ending balance sheet +$260,000
beginning balance sheet $230,000
total change plus 30,000

Owner equity in ending balance sheet 530,000 840,000

Change in owner equity plus 30,000 60,000

9









The firm's equity increased $30,000 during the quarter from the firm's production. But
it also increased $60,000 from changes in the valuation of the firm's assets. The former
shows the results of the manager's work and the latter also shows the value of this
work as well as the external factors, driven largely by inflation. Owners can use either
or both numbers as they like. The important thing is to know the difference between the
two and what the causes of these differences were.

ANALYTICAL TOOLS

The historic performance of the firm has been presented in balance sheets, income
statements and the statement of owner equity. These statements must now be analysed.
There are five basic toolboxes used in analysis. Each box contains several different
tools. These toolboxes are: 1. the liquidity toolbox, 2. the solvency toolbox, 3. the
profitability toolbox, 4. the efficiency toolbox and 5. the repayment capacity toolbox.

LIQUIDITY

This toolbox provides the tools necessary to see how "liquid" the business is. In other
words, how difficult is it to raise cash? The definition of liquidity is the ability to meet
liabilities when they become due. The due liabilities are the current liabilities listed in
the balance sheet. The cash to pay them comes from the current assets listed in the same
balance sheet. There must be enough of these, as cash, to pay current liabilities. If there
are, the firm is liquid. If there are not, the firm is illiquid. All firms must stay liquid.
Cash is their most important asset. Managers must spend a lot of time making certain
that their firms are safely liquid.

WORKING CAPITAL

Working capital is one of the major tools in the liquidity toolbox. It is calculated
by subtracting current liabilities from current assets. For example, if the firm's
current assets are $80,000 and current liabilities are $50,000, there is $30,000
working capital. In other words, after paying all the due debts, there is $30,000
left. The firm is liquid and that is good news.

QUICK WORKING CAPITAL.

Some current assets may not be quite as liquid as others. For instance, growing
crops are not as easy to sell, i.e., not as liquid, as crops waiting to go to market.
And nothing is as liquid as cash. This is the meaning of liquidity. Quick
working capital is a tool that takes the "stickiness" of some of the current assets
into account, to give a more realistic picture of what cash is actually available.
Only current assets which can be sold quickly without a discount are included.
Items which can be sold quickly include cash, savings, investments in stocks,

10









and most mutual funds, receivables that can be realistically realized quickly and
any inventory that is at, or close to, the point of sale. There will be times when
the working capital of a firm looks substantial, but the quick working capital is
negative. In other words, the firm is not as liquid as it originally looked.

CURRENT RATIO

The current ratio is calculated by dividing current assets by current liabilities.
Thus if the current ratio of a firm at a specific point in time is 1.25 to 1, this
means there is $1.25 to cover every $1 of debt due. Most firms will find it safe
to keep their current ratio between two and three, meaning that they have $2 to
$3 available to cover current liabilities. If the ratio falls below two, the manager
should make sure that he can get liquid when he needs to. And if the ratio rises
above three, he then has cash available for investing.

CURRENT DEBT RATIO

The current debt ratio is found by dividing current liabilities by the total
liabilities of the firm. It shows what proportion of all the firm's debt, both
principal and interest, is due in the next period. For example, if current
liabilities are $35,000 and total debt is $150,000, the current debt ratio =
35,000/150,000 = 0.23. This means that 23 cents of every dollar owed is due in
the following period. Obviously it is hard to generalise about any "correct" ratio
because it depends completely on the firm's debt load. But for a typical firm
with a normal debt load, it is probably useful to keep the ratio below 0.1. A
current debt ratio of 0.1 means that the firm must pay some 10% of its total debt
in the next period. Most firms will find this a difficult objective to achieve.

SOLVENCY

Solvency is a long run concept. It shows whether the firm can meet all its debts if it
sells all its assets. If the assets are greater than the liabilities, the firm is solvent. If they
are not, the firm is insolvent or bankrupt.

EQUITY

This is the single best measurement of solvency. If the firm has equity, it is
solvent. Perhaps the most useful indicator of a firm's progress is a good equity
trend.





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LEVERAGE RATIO

The leverage ratio is calculated by dividing total debt by equity. For example, if
the firm's total debts are $200,000 and equity is $100,000, the leverage ratio is
200,000/100,000 or two. In other words, the firm has $2 in debt for every $1
that it owns. Most firms should keep this ratio below one. However it obviously
depends on the situation the firm is in and the objectives and ages of the owners.
Usually younger owners will have higher leverage ratios than older owners
because the young tend to borrow more. A high leverage ratio is nothing to be
ashamed of. It is something to reduce.

PROFITABILITY

Profitability is a word that everyone recognizes but few people define. Profitability is
concerned with the returns obtained over time from some form of investing. For
example, the annual return on assets or equity will reflect the profitability of those
investments. Profit is perhaps an easier term. A common sense measure of profit might
be net firm income or net income. The distinction between profitability and profit is
important. Whether the profit is good or not depends on the amount of investment it
took to get it.

RETURN ON EQUITY OR ROE

This is an important trend to follow. It shows the return on owned money in the
firm. It is calculated using the formula:

(Net income minus owners' salaries) x 100 / beginning equity

Suppose the firm's net income for the quarter was $40,000. The owner
withdrew $16,000 for salary and the equity at the start of the quarter was
$300,000. The firm's ROE is therefore (40,000 16,000) x 100 / 300,000
8%.

The question to ask is whether this profitability indicator is the best return the
owner could get for investing his money. Or are there higher achievable returns
for investing in something with much the same risk and requiring the same
skills? This is a question that only the owner can answer. If the owner loves
what he currently does to earn 8% when he knows there are better opportunities
available, then his decision should be respected.





12









RETURN ON ASSETS OR ROA

This tool is calculated using the formula:

(Net firm income + interest paid owners' salary) xl00 / beginning assets

The interest paid on debts is added back because the firm has borrowed money
to buy assets and is paying interest as a cost of borrowing. The interest
represents the return from that part of an asset financed by borrowed money.
Part of the asset is financed with debt and part with equity and the manager
wants to know the total return on that asset. Hence the interest must be added
back to calculate the total return. Hopefully it will be greater than the cost of
borrowing. It is not sensible to borrow at 10% if the investment is returning
6%. This will happen if ROE is less than ROA. The firm is earning less than it
is paying to borrow funds.

Suppose the firm had a net firm income of $50,000 during the quarter, paid
interest of $10,000 and withdrew salary of $16,000. The assets at the beginning
of the quarter were $600,000 The ROA is therefore:

(50,000 +10,000 16,000) x 100 / ( 600,000 ) = 7.33%

EFFICIENCY

This is perhaps the most familiar toolbox to agriculturalists. Most efficiency tools refer
to the relationship between inputs and outputs. Examples include yields per acre, feed
per pound of liveweight gain, cash costs per bushel, sales per week, boxes picked per
hour of labour, etc. These types of tools are often kept by each firm and will not be
presented here, except to emphasise their importance.

OPERATION RATIOS

This tool is particularly useful in examining how costs change over time. It uses
percentage ratios that always add to 100%. The components are: 1. cash costs
excluding interest, 2. depreciation, 3. interest, 4. owners' taxes and social
security, 5. other costs not already counted, and 6. net income. All of these
components come from the income statement. Adding the six components
together gives the firm's gross output. For example, see the following diagram.






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DIAGRAM 6. A STATEMENT ILLUSTRATING OPERATION RATIOS

$ %
COMPONENTS
cash costs, excl. interest 70,000 58
depreciation 10,000 9
interest 12,000 10
taxes and S.S. 4,000 3
overhead 4,000 3
net income* 20,000 17

GROSS OUTPUT 120,000 100

This is the residual from subtracting all the costs from the gross output

The interpretation is that 17% of the firm's gross output results in net income, 58%
goes on cash costs excluding interest, 10% on interest and so on. Put another way, for
every dollar that the firm generated in that quarter, 17 cents was net income, 58 cents
went on cash costs excluding interest, etc. The most useful thing about this tool is
spotting trends. If, for example, interest costs took an increasing share of each gross
output dollar, the manager has some decisions to make.

ASSET TURNOVER

Firms have to know how quickly they turn their assets over to generate output.
The basic definition for asset turnover is Gross Output / Average Total Assets.
The greater the ratio, the better the assets are used. For example, if the firm
produces $1,000,000 gross output in a year and its average asset valuation was
$5 million, the turnover ratio is 20%. One fifth of its assets turn over annually.
But because of the almost unique asset fixity in agriculture (i.e., the land
domination of assets) another denominator might be more useful. For those
firms who have more than 30% of their total asset values in land, remove land
from the denominator and work with the remaining assets. Then compare the
turnovers with and without land.

REPAYMENT CAPACITY

There are three main repayment capacity measurements and they all focus on how the
firm can pay its debts. Note that these three measures ignore both the principal and
interest of operating debt. It is assumed that operating debt will be repaid as the output
it financed is sold. So unless any operating debt is carried over from the previous
period, it is excluded from the formulae.


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COVERAGE RATIO

The coverage ratio is calculated using the following formula:

net income + depreciation + interest owners' salaries and taxes

annual principal and interest payments

The higher the ratio, the easier it is for the firm to meet its debt commitments. If
the ratio is one, it can just meet them. It also means that the firm is living, to
some extent, off depreciation to service the debt. In other words the firm cannot
replace any of the capital depreciation with new purchases. Anything greater
than one gives the firm room to do other things.

For example, with a net income of $40,000, depreciation of $11,000, interest of
$10,000, owners' salaries and taxes of $26,000 and principal payments of
$13,000, the coverage ratio of this firm is:

$40,000 + $11,000 + $10,000 $26,000
------------------- 1.52
$13,000 + $10,000


The coverage ratio of 1.52 means that the firm can meet all its current debt
obligations and still have 52 cents available for other uses.

CAPITAL AND DEBT MARGIN

This ratio is essentially the next step up from the coverage ratio. It shows
whether the firm can both meet its debt and afford to replace the capital assets
lost in producing its net income. The capital and debt margin =

net income + depreciation owners' salaries and taxes principal payments

For example, using the numbers from the previous example, the capital and debt
ratio of this firm is:

$40,000 + $11,000 $26,000 $13,000 = $12,000

which means that there is $12,000 available after paying its current debt
obligations and covering depreciation.



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DEBT TO INCOME RATIO

The debt to income ratio is calculated using the following formula:

average total liabilities / net firm income

The average total liabilities is calculated from adding the liabilities of the
beginning and ending balance sheets together and dividing by two. The ratio
shows the number of times that the firm's debt exceeds its net firm income. For
example, if liabilities are $300,000 and the net firm income is $50,000, the ratio
is six. This means that, at the current rate, it would take six years for the
income to equal debt. If the ratio falls to five, then its income leverage is
reduced and the firm has reduced its risk. If the ratio rises, then income
leverage is increasing, increasing the firm's risk because it becomes increasingly
difficult to service this debt from current income.

SUMMARY OF WHAT DID HAPPEN

Managers, by necessity, use past performance to see how the firm is doing. This
synopsis, using balance sheets, income statements and statements of owner equity,
provides the raw data for the five analytical tools of liquidity, solvency, profitability,
efficiency and repayment capacity. The manager is expected to produce answers from
this analysis that will show whether the firm is meeting its objectives and to help
formulate new objectives. But, unfortunately, analysis is neither entirely scientific nor
precise. Analysing the financial health of a firm involves experience and intelligent
guesswork in much the same way that a doctor assesses and makes conclusions on the
physical health of a patient.

Perhaps the most important part of this assessment is to estimate what the firm or the
patient will look like in the future. It is this estimate that produces the objectives of the
firm by bringing past performance and future predictions together. Analysis of past
performance and knowledge of the present situation formulates what the firm can do in
the future. These future predictions use the tools on the right hand side of Diagram 1,
and will be presented now.

BUDGETING

Budgeting is trying to plan future expenditures and match these in some way with
future sales and other dollar inflows. It is one of the most important functions in
running a firm. No one knows the future, so budgeting results will usually be wrong.
But it is essential to try. A budget is a map for the future of the firm and no one should
go on a journey into the unknown without a map. And as with a journey, budgeting
estimates change as circumstances change. The procedure is to start with budgeting the

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firm's individual enterprises. These enterprises are then added together to make the
firm budget. The firm budget is then used to produce the cash flow for the firm.

ENTERPRISE BUDGET

A generalised enterprise budget is shown in Diagram 7. Realise that the blanks under
each category are where the individual items making up that category are entered. For
example, the items of fertilizer, chemicals, labour etc would go under cash costs.
Realise also that the sums of the different categories are shown by a capital letter.

DIAGRAM 7. A GENERAL ENTERPRISE BUDGET

Anticipated sales and costs of producing one (UNIT) of enterprise(NAME) in (WHERE) in (YEAR)

$ per UNIT
SALES

*anticipated (yield_) x anticipated (price_) = A

COSTS AND INDICATORS

(1) Cash costs

Total cash costs = B

GROSS MARGIN (A) (B) = C


(2) Depreciation

Total depreciation = D


(3) Overhead( prorated) = E

TOTAL COSTS (B) + (D) + (E) = F

NET ENTERPRISE INCOME (A) (F) = G

(4) Owners' estimated taxes and SS (prorated) = H

NET INCOME (G) (H) =

MINUS (PRORATED)
1. salary to owners = J
2. principal payments = K
EQUALS
amount left for buying assets = L
i.e., (I) (J +K)

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There are a lot of things to discuss in this diagram. Firstly, sales have proxied for gross
output. If it is possible to budget the gross output of the enterprise, inventory changes
and all, it should be done. But as sales are usually easier to estimate, and as they
typically make up at least 90% of the enterprise gross output, they are a good proxy for
gross output.

Secondly, the diagram shows that each enterprise has to play its part in meeting all the
firm's outlays. Some items like the cash costs are directly applicable to an individual
enterprise. For example, the fertilizer applied to a specific crop is charged entirely to
that crop. Others, like depreciation, are not as directly applicable, in that resources like
machinery are usually shared among all the enterprises. So some form of cost sharing
needs to be done to allocate this type of cost to the enterprise. In other words, items
like depreciation must be prorated. The alternative is to diligently record the number of
hours etc. that an individual machine (for example) spends on each enterprise. This
practice is rarely realistic, though it would usually provide better information.

The practical alternative is to have a simple method of cost sharing and later modify it
as experience is gained. One of the simplest methods is to share the item in the same
proportion as sales are shared. For instance, suppose a firm gets 70% of its sales from
one enterprise and 30% from a similar enterprise. The depreciation could then be
prorated between the two enterprises 70% and 30%. And if later experience shows that
the smaller enterprise uses slightly more of the firm's depreciable capital assets per unit
of output than the larger enterprise, the prorated shares might change to 65% and 35%.
The sales percentage model is just one method. Sharing according to cash costs is
another possibility. So is sharing based on experience. The important point is that each
enterprise must cover these prorated items in order to contribute to the firm's profit.

Thirdly, the diagram shows that each enterprise must contribute to owners' taxes,
salary and principal payments. This contribution is obviously essential, but is
unfortunately not often seen in a specific firm's enterprise budget. The prorating
method should be simple, and modified as experience dictates. Again, the essential
point is that each enterprise must be able to cover these items. If it cannot, then the
budget should be reassessed. This means examining the costs and the prorated numbers
including the projected salaries. If the reassessment does not produce a positive number
to re-invest in the firm, the manager needs to consider how much longer he wants to
produce this enterprise because it is currently not paying its way.

Assume that the enterprise does generate a positive "L," and that the firm owner is
considering its production. A positive L is a necessary but not yet sufficient reason to
produce it. Fourthly and finally, there are at least four questions to answer now before
the enterprise is produced. These are: 1. are there enough resources available to
produce it? In other words, is there sufficient land, labour, debt and equity capital and
managerial ability available? 2. is there a market for this enterprise and what must the

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firm do to get the enterprise to that market? 3. what must done to the enterprise before
it is marketable? For example, how must it be prepared, graded, packaged, transported
etc? 4. what are the production, financing and marketing risks involved (yield; cost
and price volatility; capital availability as well as the effects of weather, pests,
diseases, breakdowns,strikes, etc)?

If the answers to these four questions look good, then: 1. repeat the process with other
possible enterprises, 2. select the ones that look the most profitable, 3. combine these
enterprises into a firm budget.

COMBINING SELECTED ENTERPRISES TO MAKE A FIRM BUDGET

The procedure is to firstly, list the enterprises in a table; secondly, complete the row
names in the table; thirdly, calculate the net enterprise incomes from each enterprise
and, finally, add across the table to produce the firm budget. The net enterprise
summation provides the net firm income and the salary, principal and re-investing totals
show how the firm's net income is budgeted. A reasonable layout for this exercise is
shown in Diagram 8, which also includes the projected numbers for the five enterprises
and a total.

DIAGRAM 8. ENTERPRISE AND FIRM BUDGETS: A METHODOLOGY
($'000)
ENTERPRISE BUDGETS FIRM BUDGET
CATEGORIES 1 2 3 4 5 TOTAL

SALES 250 200 150 100 100 800

Cash costs 150 120 80 60 60 470
Depreciation 36 29 22 14 14 115
Overhead 14 11 8 6 6 45
TOTAL COSTS 200 160 110 80 80 630
NET ENTER INCOME 50 40 40 20 20 170
owner income tax +ss 10 8 8 4 4 34
NET INCOME 40 32 32 16 16 136
salary 15 13 10 6 6 50
principal 12 10 8 5 5 40
re-investing 14 12 8 6 6 46


The table shows the contribution of each enterprise to the firm and how each
contribution is shared among the outlays. Thus the owner expects the firm to have
around $800,000 in sales, to pay some $470,000 in cash costs, use up about $115,000
of capital assets as depreciation and to prorate the $45,000 overhead between the

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enterprises as shown in the table. Consequently the owner will have to pay around
$34,000 in income and social security taxes, leaving a net income of $136,000, which
is allocated as shown between salaries, principal and re-investing in the firm.

THE FIRM CASH FLOW

The cash flow is a planning tool stemming from the firm budget. It is also the final
planning tool, before resources are allocated to produce the firm's enterprises. The cash
flow plans the future inflows and outflows of cash in the firm over a specific time
period. It also shows cash in the business at the start of the period and cash left in the
business at the end of the period. Examples of cash coming into the business include
sales, new borrowing, other firm income and new equity. Examples of cash leaving the
business include cash costs, principal payments, owners'salaries, asset purchases and
owners' income taxes and social security.

The cash flow does three things. It predicts, monitors and presents decision making
data. It predicts the future cash inflows and outflows within specific time periods,
usually monthly. It monitors these monthly predictions by comparing the monthly
estimates with what actually happened during the month. Finally it helps the manager to
make decisions on the difference between the predicted results and the actual results.
For example, suppose August sales were predicted to be $60,000, but were actually
$40,000, or 33% less than the estimate. What decision should the manager make? The
answer, of course, depends on why the sales were down. If it was because the market
price fell, or yields or quality was down, then some future adjustments will be
necessary. But if the output was not quite ready for sale, then perhaps only September's
numbers should be adjusted.

If cash is unavailable when it is expected, there is more than sales to consider. Cash
outflows were originally matched to the inflows. If inflows fall, then cash commitments
such as debt service, payables and salaries cannot be met. Consequently other cash
sources must be tapped to meet these commitments. A properly used cash flow shows
what is happening and suggests what the consequences will be when predictions have to
be changed. The cash flow is constantly changing and provides the manager the cash
map necessary for cash management.

Cash flow forms vary and no one basic form fits every firm. It is more important to
have a good cash flow system than worry about form uniformity. A good system should
run for three years and as it becomes increasingly difficult to predict that far in
advance, each year will present less detail than the year before. For example, the first
year of the system typically uses monthly columns, the second uses quarters and the
third an annual column only. Rows can also be simplified. The monthly columns would
show, for example, the different types of chemicals to be used in individual rows, while
the third year annual column might show all the chemicals combined in a single row.

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There is nothing wrong with designing an individual system that fits a specific firm. It
seems reasonable for firms that essentially operate six months a year to have more
columns, weekly or monthly, in their busy times and perhaps have the remainder of the
year reflected by quarters. The important point is that a cash flow must be used
constantly to be useful. Including unnecessary detail is almost as bad as excluding vital
data. Always keep 12 months ahead in each of the three cash flows in the system. When
one month passes, introduce the same month in the following year. And as a quarter
expires, predict the following quarter in the second cash flow.

A simplified cash flow layout is shown below. This can be modified to fit the system in
any firm.

DIAGRAM 9. A BASIC CASH FLOW LAYOUT

Time Time
Period 1 Period 2
opening cash
balance

CASH IN
sales
other cash income
new borrowing
new equity additions

Total cash available (A)

CASH OUT
cash costs
owners' salaries
asset purchases
principal payments
owners' taxes and SS

Total cash spent (B)

(A) (B) is closing cash
balance


Any one of these row names can be divided into its components, to provide detail or
summarised to present a succinct picture. It may also be useful to use a separate loan
section in the above diagram to itemise each loan and keep a running total of the current

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debt situation. The cash flow times debt repayments. It shows when there is cash and
when there is no cash. Use it to present sensible debt scheduling to lenders. It is the
firm cash flow rather than the lender which shows what can be done in paying interest
and principal. Make sure that all parties involved understand this.

The cash flow also incorporates new events. As events change so will the firm results.
Thus the cash flow must be changed constantly to reflect these changes and to reflect
increasing knowledge of what will happen to cash inflows and cash outflows. The
alterations show the results of the changes.

The cash flow shows when the firm can afford to buy assets. If the cash is not there
and the asset is needed, it shows the consequences of increasing the debt load. It also
shows how much salary can be drawn by the owners and the consequences of paying
salary rather than spending the cash on other things.

Monitoring compares predictions with what actually happened. Predictions will be
wrong, and the further away the predictions, the less accurate they may be. But the firm
has to buy and use resources such as fertilizer and labour before it produces sales and
make a hoped for profit. These are normal business risks. The cash flow helps to think
through this process.A good cash flow shows more than just predictions. It also shows
the actuals, side by side with the predictions. Diagram 10 shows the next step.

DIAGRAM 10. THE PROPER CASH FLOW ($'000)

JULY JANUARY TO JULY
ITEM predict actual diff predict. actual diff
sales 40,000 0 (40000) 300,000 276,000 8% down
costs 30,000 32,000 2,000 200,000 205,000 3% up
salary 3000 3000 0 21,000 24,000 14% up
prin. pt 5000 0 (5000) 30,000 25,000 17% down

This cash flow has three sets of columns, shown in the diagram as "item," "July" and
"January to July." It also simply illustrates some rows rather than presenting them all.
The diagram's layout is used for the nearby cash flow only. One set of columns (Item)
lists the row names as before. The second (July) lists the predicted monthly cash
results, the actual monthly cash results and the difference between them. The final set
(January to July) lists these same three columns for the year to date. The idea behind
this final set of columns is to prevent over- reaction to temporary events when the firm
is basically still on track. Thus decisions should be made from the last column in the
diagram rather than the monthly difference column.

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For example, there were no sales in July when the prediction was $40,000. This could
be alarming, but the last column shows that the firm is only 8% down in sales for the
year to date. So if the product was not quite ready for sale in July, then there is not
much to worry about. Sales predictions have been pretty good. (Another story if there
were other reasons for no sales in July, such as poor quality or price falls). Costs are
also well predicted. The reason for no principal payments in July was because there
were no July sales. The only problem with these numbers is that salary is higher than
was predicted and this needs to be watched.

It is probably more useful to use percentages than numbers to express the differences
between predicted and actuals. Percentages summarise the differences better. For
example, a reduction in sales of $1 million looks startling, but if it is equivalent to a
3% drop, this does not seem too bad. So the essential purpose of the cash flow is to
make decisions doing the cash flow and working with it. Producing, reviewing and
using a cash flow are among the hardest tasks that a manager can do. But because cash
is so vital today, it is this task that brings the highest reward.






























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