When a 350-cow michigan dairy put its expansion plan together, the owners felt confident in their financial projections — and so did their lender. However, part way through the expansion, they ran short of cash.

An analysis of their balance sheet revealed the problem. Stored corn was reported as inventory, but a corresponding Commodity Credit Corporation loan for the corn was unaccounted for on the balance sheet. So, their working-capital calculations were way off, explains Mike Fassler, president of Salisbury Management in Portage, Mich. If they had used a double-entry accrual accounting system, the mistake would have been prevented.

“They didn’t like having to go back to their lender with their hat in hand to ask for more money,” says Fassler. “But because they learned a valuable lesson, this now 1,200-cow dairy has great financial records, and the owners are more efficient and effective decision-makers than ever.”

Good financial records, combined with the ability to correctly interpret that data, give managers much more confidence, which, in turn, creates more energy and drive to see the business through even in tough times.

Following are eight of the most common mistakes made when interpreting financial records and how to avoid them.

1. Using your Schedule F tax form to judge profitability.

A schedule F tax form is completed on a cash basis and, therefore, is not a measure of profitability, explains Darrell Dunteman, accountant and agricultural financial consultant in Bushnell, Ill. However, when the schedule F shows a positive number, many producers assume that it means the business is profitable.

Because the schedule F is done on a cash basis, many producers make adjustments at the end of the year to minimize the taxes due. For example, they hold off on grain sales or have the co-op defer payment for milk sold during the last couple of months of the year in order to defer income until the next year. Or, they may forward pay for next year’s fertilizer or feed. Cash-based accounting only reflects money in and money out of the business.

If you want to judge profitability from your schedule F, you must make the three accrual adjustments listed below.

Schedule F cash income
+/- Change in inventory
+/- Change in accounts payable
+/- Change in prepaid expenses

2. Net income means nothing by itself.

When it comes to the accrual income statement, some people think the only number that matters is net income. “When they see they have $1.2 million in net income, they say ‘I’m good,’” says Bob Matlick, partner at Moore Stephens Wurth Fraizer and Torbett LLP in Visalia, Calif.  But net income does not account for owner draw, principal payments, depreciation, change in herd size, and income from culled cattle. Once these are factored in, the result could be very different.

3. If it cash flows, it must be profitable.

Cash-flow statements are one of the most abused financial statements  out there, says Kevin Dhuyvetter, agricultural economist at KansasStateUniversity. Many mistakenly believe that cash flow is a barometer of how the business is doing. But cash flows only tell you cash in and cash out.

When doing cash-flow projections for an expansion project, some people assume that if it cash flows, it will be profitable. But to judge the profitability of a project, you must look at return on assets and return on equity. If these two parameters are in line, then whether or not the investment will cash flow is often related to debt structure. 

Another common problem with cash-flow projections is that producers tend to work the numbers backward, adds Matlick. They want to know how many cows they need to make the project work. But it’s not the number of cows that is critical to pay the bills; it is the pounds of milk shipped each day. When doing cash-flow projections, you need to know how many pounds of milk you need to ship each day — and at what price — to succeed.

4. Not reading the footnotes on financial statements.

Many people assume that the numbers on a financial statement provide the whole story. However, you must read the footnotes. They will disclose if any litigation is pending; if land was just sold; the number of cows sold; if a 1031 real estate exchange is pending; and the depreciation method used, to name a few. These footnotes tell the story behind the numbers and put everything into context.

5. Using the balance sheet incorrectly.

Do not use the balance sheet to benchmark your farm against another farm. The balance sheet is a report card of how your business is doing on the date it was prepared, says Matlick. Use it to evaluate how your business performed.

For example, your balance sheet will tell you how money was used, such as for purchasing cows or equipment. Always compare your current balance sheet to your last one -— either yearly or quarterly. And always use the same type of valuation, market value or cash value, to prepare it every time.

Another mistake, says Fassler, is to prepare the balance sheet independent of your accounting system. This makes it easy to grossly overstate or understate your current position. For an accurate balance sheet, always pull the data from your accounting system, and always use a double-entry accounting format -— it will help prevent errors. 

6. Calculating financial ratios on a cash basis.

When you use cash-based information to calculate common financial ratios, it can provide you with a questionable outcome. In some cases, it will inflate the ratio so that you believe your business performs better than it really does, says Dunteman. Always use accrual-based financial information when calculating financial ratios. 

7. Relying too much on debt per cow.

“In the dairy industry, we focus too much attention on debt per cow,” says Dhuyvetter. While debt per cow is a good starting point, most people assume the lower the number, the better. But that is not always the case. Debt, when used wisely, can be a good thing.

For example, if your return on assets (ROA) is 10 percent, and you can borrow money at 6 percent, then using debt to grow your business is a good strategy. However, if your ROA is 5 percent, and the cost to borrow money remains at 6 percent, then borrowing money isn’t wise. 

The other problem with debt per cow, when used by itself, is that different management styles require different levels of debt per cow. For example, the investment required for free-stalls compared to dry lots, or the use of cow-cooling systems throughout all areas of the dairy compared to just shades, will result in substantially different levels of debt per cow. Instead of looking at debt per cow, he recommends that you look at the debt of the business as a whole in conjunction with the ROA it generates.

8. Not realizing that you are comparing apples to oranges.

Done correctly, benchmarking can be a powerful tool. However, when comparing cost categories from your farm’s income statement with another farm’s, you must know the context of the numbers. Differences in management style and adoption of technology can greatly influence individual cost categories. And, if you don’t understand these underlying differences, it can lead you to make some bad decisions.

For example, if one of the producers in your comparison group has switched to no-till farming practices, and everyone else in the group uses conventional tillage, the no-till producer will have lower fuel, repairs and labor cost. The same holds true for cost differences in Holstein and Jersey herds or in dry-lot versus free-stall operations. You can’t just look at the cost categories and compare. You must know the full context of the numbers presented. To do that, Fassler recommends asking the following when benchmarking against other producers:

1.         How were the data prepared?

2.         Do you use cash or accrual accounting?

3.         Is the inventory done on market value or cash value?

4.         Does labor cost include the owner’s draw?

5.         If BST is used, then what cost category is it reflected in — veterinary cost or somewhere else?

Use the cost categories from your income statement to help determine the areas within your operation where you may be able improve your bottom-line profitability.

Yet, ultimately, the best benchmark of your operation’s profitability will be ROA.

Accrual vs. cash

farming is one of the few businesses that can report taxes on a cash basis. But producers also need accrual-based accounting to help them understand what is truly going on in the business. 

However, many people still don’t understand the difference.

Cash-based accounting is simply a listing of money in and money out. So, for example, if you bought three semi-truck loads of alfalfa in January, and pay for all of it in January, you might show a loss for the month. However, since those three loads of alfalfa will last though March, your feed cost will be lower in February and March, which also would improve income in those months. 

In contrast, with accrual-based accounting, the inventory is accounted for and charged against the business at the time it is used. Using accrual-based accounting gives you a true understanding of what is happening in the business.