How to Manage the Flow of Cash in Your Operation
We explored in Financial vs. Managerial Accounting the essential information farmers need to make good economic decisions. Today, we are going to look at how the interpretation of financial accounting reports can be essential to your farm’s financial health.
Financial Interpretation—Using the Big-Picture Approach
Reporting at the entity level gives you the bigger picture of agricultural accounting because it gives you insight into how you are performing in both operation and capital management. Using the big-picture approach allows you to move from macro to micro, expanding the opportunities for the farm by analyzing information that allows you to initiate change if needed.
The traditional approach of farm business owners has been to pick specific events and then attempt to determine the cause and effect each has on the farm. This puts us in the mindset of status-quo (in-the-box) thinking and thus limits our ability to fully maximize opportunities.
Take time to think about how you want the future operations and capital areas of your business to perform. Then, use your entity information to develop targeted financial objectives that will help you take steps to the future outcome you want to achieve, and develop detailed plans to reach those objectives.
In analyzing your records, you will identify which of the four scenarios from the following table applies to your business. Thus, you will have a roadmap for taking control of the farm’s financial performance by evaluating opportunities, correcting problems, and deciding how you want the financial portion of your business to function, giving you a sense of control and security.
Consider this as it relates to the type of personality you have when it comes to the farm. Generally, individuals are either risk takers or security seekers. The risk taker is generally trying to advance the cause or mission of the operation, while the security seeker is looking for a forward progression with a solid foundation. In some of the most successful operations, these two personalities work together to create an outcome that furthers the growth of the operation.
Without the proper balance, you will find risk takers taking risks that put the operation in jeopardy or, on the opposite end of the spectrum, security seekers who are too cautious to advance the operation when necessary. This failure to act can put the operation at jeopardy just as much as the risk takers’ approach.
Is the operation providing enough profit to produce the flow of cash it needs to pay for the following?
- Family living/owner withdrawals
- Term debt principal payments
- Asset purchases
Ensuring sufficient funding will come from proper analysis of the operation’s financial health and the right approach to application. When the farm’s operation is properly funded, then both personality types can be satisfied while advancing the operation.
Using a rain cycle analogy, we can see the flow of money through a profitable farm business. Debt and equity are used to fund assets. Assets are used to generate revenue, which is converted to profit. Profit is then applied to debt and equity, which are used to fund assets, and the cycle continues.
Several years ago, AgriSolutions Inc. conducted a comprehensive study to identify why some businesses were more financially successful than others. We addressed two questions: “How can businesses that are essentially identical in size and productivity have completely different financial results?” and “What did the more successful businesses do to make them more successful?” What emerged from the study was that the successful farms tended to follow a similar pattern in the use of their operating profit. You have probably always wanted to know the inside scoop on other farms that are successful. Well, as it relates to their financial success, we can identify a distinct pattern we call the AgriSolutions Rule.
The AgriSolutions Rule
All farm financials have four basic components: operations (the income statement), assets, liabilities, and equity (the balance sheet/ financial statement). To be successful over time, profits from operations must fund the remaining three parts of the business (assets, liabilities, and equity) plus interest. Interest, while an expense, is a capital expense, not an operating expense, and it is excluded from the operating expenses.
We observed that our most profitable farm businesses tended to divide the use of operating profit in specific ways. They used less than 50% of the operating profit to cover a combination of interest and owner withdrawals, leaving more than 50% of the operating profit available for debt reduction, asset acquisitions, and risk. Usually, the first 50% is divided about equally between interest and owner withdrawals—25% each. The 50% or more that is remaining is available for debt reduction, assets, and risk. Over a lifetime, it is usually evenly divided between debt and assets, 25% each. Therefore, the AgriSolutions Rule is to allocate approximately 25% of the operating profit for each of these four areas.
The foundation of your farms’s future prosperity has a lot to do with financial stewardship. The slow and steady discipline of financial balance weathers the storm of volatile markets.
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