Don’t confuse money in the bank with profitability
You look at the December bank statement. It shows a checking account larger than a year ago. You’ve had a profitable year, right? Not necessarily. Just because you have money in the bank does not mean you made money. It may seem strange, but profitability and money in the bank are two different things, even though they sound a lot alike. How can that be? Let me explain.
Profitability is tied to the management decisions you’ve made that generate income. Simply stated, if what you’ve spent to raise crops or livestock is less than what you earn from those crops and livestock, you’ve made a profit. That profit came from new investment, not existing assets.
The cash conundrum
Where producers may get confused is when they acquire cash from either non-production activities or the sale of existing assets. For example, you might receive an inheritance and put that money in the bank. You now have more in your account but you didn’t generate that cash yourself.
Another example: You sell a capital asset like a tractor and deposit that money into your checking account. Again, you didn’t produce a profit but, rather, realized a capital gain. Also, I often see farmers refinance a capital asset like farm ground and put the money in the checking account. Or, sometimes they take equipment that’s paid off and buy a new piece of equipment and borrow the maximum amount they can with the additional cash going into their checking account.
A similar problem can arise when income isn’t realized the year it is generated. Let’s say on January 1 you have 100,000 bushels of last year’s corn in the bin and at some point during the year you sell that bin of corn along with this year’s corn, so that there’s no corn left. You could end up with more money in the bank than last year but still be losing a lot of money because you turned two years of crops into cash all in one year.
The bottom line’s bottom line
Why is all this important? Because money in the bank does not equate to farming success. One-time cash infusions do not measure your annual profitability. Instead, profitability is measured over years, and the most important question is whether those numbers trend up or down.
When I think of profitability I think of liquidity. If your short-term assets minus your short-term liabilities have widened over time, then you’ve probably done some things right, especially if your earned net worth gain has come up. But if it has shrunk, you could still be profitable tax-wise, or still have money in the bank, but be on a route that could lead you into some severe issues around the corner. If you don’t have enough liquidity, you can’t continue your operation. Liquidity is how you pay the light bill.
A deep dive on cost/return
A good way to identify if you’re running a profitable operation is by conducting an enterprise analysis. An enterprise analysis is an in-depth look at each part of your operation to determine what that activity costs versus what it returns.
A cattle operation is probably the easiest example. If you’re running a feeder cattle operation and you bring them all in on January 15, sell them on December 15, and all the bills get paid before the first of the next year, it’s easy to see if you made money on that group of cattle. Where it gets a little bit tricky is if you had to use a lot of hours in tractor time, or you had to buy a bigger tractor or hire a bunch of labor to go into the cattle operation. Those costs have to be factored into the enterprise analysis. A good enterprise analysis will help you determine the true profitability of each of your operation’s various parts individually and even if they’re not as simple as this cattle feeding example.
Farm hobbies should be included in an enterprise analysis too, too. I say “hobbies” because they start out as good ideas with one antique tractor, and then suddenly you own 40 of them. Or maybe you own fancy horses or breeding stock and soon you’re buying a semi because it is needed for the grain work to feed those horses, then you also buy a couple of trailers to transport those horses to shows. A lot of people don’t know what the cost of their hobbies are because they lump them together with the productive portions of their operations.
Tractor pulling is probably the best example of this. I’ve never known anyone who has done that profitably. They end up blending a lot of the cost of that hobby into other parts of their farming operation, lowering their overall profitability. Without an enterprise analysis you might think that the farming operation is limping along when in reality it’s going gangbusters but your hobby is sucking out all the profit.
Know your cost of living
As a producer you have to closely monitor what you spend and take in. That comes from good recordkeeping. You’ve also got to be honest with yourself. If the county average is 205 bushels to the acre and you haven’t marketed more than 180 bushels across the scales for 10 years, you probably should be using 180 bushels for your cash flows and planning everything else around that number.
Finally, how much money are you actually living on? I don’t think I’ve ever seen anyone understate the amount of money they withdraw each year. I’ve always encouraged the groups I work with to determine what their management should be paid, and then separate that money out each month.
If you need assistance running an enterprise analysis, developing a management plan, or on debt restructuring advice, we at Ag & Business Legal Strategies are here to serve you.
At Ag & Business Legal Strategies, we want our clients to be honest with themselves and have a solid business plan. Our attorneys and financial strategist will help you create and execute that business plan, and, if necessary, assist you with the legal, tax, and practical aspects of debt restructuring or bankruptcy. Don’t wait for the problems to become insurmountable. Connect with someone you can trust today, not tomorrow.
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Categories: Economy, Farm Business