Fences have been used for centuries for identifying property lines and to corral and protect livestock. A similar structure can be utilized to protect financial integrity, your business from certain risks and to facilitate the production of wealth. Don Hofstrand of Iowa State University refers to this structure as the “Solvency-Liquidity Fence”.
Building materials for the “Solvency-Liquidity Fence” are very low in cost and are readily available. Similar to the building of any good, strong, functional fence it does take a minimal amount of planning and dedication along with a fair level of effort to realize available, substantial benefits. The bill of materials for this project includes beginning and ending Balance Sheets (BS), a Farm Earnings Statement also known as an Income Statement (FE) and a Cash Flow (CF) Statement.
A CF Statement is a listing of the cash in and out flows for your business over the accounting year, typically a calendar year for many farm businesses. Although related, Cash Flow and Profit are different!
While the CF Statement lists cash in and outflows from the business, the FE Statement calculates Net Income. What is the difference? Most cash inflows are income and cash outflows are expenses depending on the timing involved. For purposes of cash flow incomes are only inflows when the check is received and similarly, expenses are outflow when the check is written. In contrast, the FE Statement records income as it is produced and expenses as they are incurred regardless of when the cash transaction takes place.
This also includes farm production inventory. Feed and cattle inventory on many dairy farms represent significant dollar value. But they only produce cash inflows when sold or fed to produce milk and cattle and the product is sold. In contrast, their dollar value when held in inventory must be considered in the year’s production to adequately credit the business for produced value. When current inventory dollar values increase from one year to the next they add to business Liquidity, the ability to meet cash obligations as they are due, and Solvency, a positive Net Worth, but lower Liquidity and Solvency when inventories decline.
Asset value changes including production inventories are recorded on the business BS. These changes are also accounted for on the FE Statement to account for their impact on business profitability. Net Income or loss for the period increases or decreases the Net Worth of the business as shown in the ending BS compared to the beginning BS. Likewise, business asset and Liability value changes based on the value of goods produced reflect on whether the year in question was profitable. Thus when negative cash flows and/or profit occur as reflected on the CF and FE Statements, adjustments are also made in the BS level of Solvency. These adjustments can be in the form of reduced asset and/or increased liability dollar values.
The BS, FE and CF Statements are referred to as “integrated financial statements” for the reasons defined above. While each serves their own purpose in tracking very specific information and allowing individual summary calculations they are also related. Like first cousins, they contain some of the same genetic (financial) material but each have their own unique purpose amongst the family of financial statements in providing specific information about the life of your business.
The BS is a snapshot of the Solvency of the business at a specific moment in time. The amount by which assets exceed liabilities is the “Net Worth” of the business. The FE Statement is a dynamic accounting of the incomes and expenses over the accounting period. The CF Statement accounts for all inflows and outflows of cash over the same period. The complete set of statements represents a decision tool allowing a comprehensive analysis of your business.
The “fence” for the present year also forms the base structure for the coming year. From it the Solvency and Liquidity momentum for the coming year is set. From this foundation you can plan/budget for the coming year by projecting cash inflow and outflows, thus facilitating risk management strategies that lower stress and identify business opportunity.
Are you interested in planning for the next swing in volatile milk prices and production input costs? UW-Extension can help you get the job done! Contact your farm records association field staff, technical college farm trainer or local UW-Extension Office. This educational program is support by a North Central Risk Management Education Center Grant.