The Agricultural Income Statement - What You Need to Know

Newsletter #9

I’ll keep the intro short this time as we got a long one on our hands.

Financial literacy is a vital part of running any kind of business. That is why I decided to launch a short mini-series on the financial statements.

Hope it’s useful 🌷

To set the stage, financial statements simply tell you how your business is doing, financially speaking. And you got three different statements to tell you this: the income statement, the balance sheet, and the cash flow statement.

• The income statement shows how much money you bring in and how much you spend to achieve this

• The balance sheet is a ‘snapshot’ of what you own (like your cash, equipment, and livestock), and how you paid for this (like loans or your own money).

• The cash flow statement ties it all together and shows you how the most precious thing in your business (cash!) changed over the year.

My take on Financial Statements

But before we get into it, I’m going to say something controversial. Because if I’m honest, I don’t think they are all that useful to run your business…

The way I see it, financial statements are crucial for reporting purposes, but not for making management decisions. They're mainly designed to give other people (like banks or investors) a snapshot of your financial health.

I believe this even more for seasonal businesses, like most farms.

Because take this example. You look at your financial statements and see you got a 15% net profit margin. All this tells you is that you, in the accounting world, created economic income. This does not tell you that in July during harvest you had no money coming in to pay your employees. See what I mean? They don’t tell you the real day-to-day picture. It only says that at the end of the year, you made a profit. (The day-to-day is where the Cash Budget comes into play).

The Mini-Series

But before you close this edition, there is still a time and place for them, as I will discuss later on!

This week I’ll cover the Income Statement, next week the Balance Sheet and the week after the Cash Flow Statement. All editions will have a bit of an Agriculture twist to them and contain some real examples.

The Income Statement

The income statement shows your revenues, expenses, and net income (or net loss) over a specific period of time.

Ultimately, this profit/loss flows into the equity that you are building in your business. Hence, we do want to know how this develops over time to judge whether it makes sense for you to continue putting your blood, sweat, and tears into the business.

I don’t have to tell you that Profit is simply your revenue - total expenses. Revenue is often well understood. But it’s all the items that make up this total expenses column that can be confusing. Let’s break it down:

Income Statement Breakdown

• Revenue: the total income earned by the business during a given period (e.g. a year). It will include all sales of crops, livestock, and items produced, as well as any other income such as rental income from leasing land or buildings, or income from custom work for others.

• Cost of goods sold (COGS): the direct costs incurred to produce the goods sold during the period. For example, the cost of seed, fertilizer, pesticides, and other inputs used to grow crops or raise livestock, or the cost of production (e.g. mining, extraction, refining) for commodities sold. Another way to think about it, COGS is the inventory (from the Balance Sheet) that was sold during the period.

• Gross profit: the difference between revenue and COGS. It represents the profit generated from the primary production activities.

• Operating expenses: the indirect costs associated with running the business, such as labor costs (e.g. wages, payroll taxes, benefits), rent or lease expenses for land, buildings, or equipment, utilities (e.g. electricity, water, gas), repairs and maintenance, supplies, and depreciation (the portion of the cost of long-term assets such as buildings or equipment that is allocated as an expense each year).

• Operating income: the difference between gross profit and operating expenses. It represents the profit generated from the operations before accounting for interest, taxes, and other non-operating expenses.

• Other income and expenses: includes interest income and expenses, taxes, and other expenses such as legal fees or insurance premiums.

• Net income: the final profit or loss earned by the farm during the period. It is calculated as operating income plus other income minus other expenses and taxes.

The Income statement in action

I worked with one business that saw its net profit decline over the last 2 years, while its revenue increased. It ‘felt’ like the business was making more money, but it actually wasn’t building more wealth.

By looking at the income statement, we could see that its gross profit margin remained the same, but its operating profit margin was lower. Meaning: while production costs remained the same, the indirect costs had risen.

By further digging in it was obvious that the increase was caused by a significant increase in labour costs and repair and maintenance costs. This set off a review of labour efficiency, which showed the possibility to change certain full-time contracts to part-time. And it highlighted the need to look at some of the equipment and posed the question of whether leasing equipment would be a better strategy than buying.

That’s how I believe the income statement should be used: as a tool to look at larger trends in your business to make long-term decisions.

The agricultural twist

Finally, some unique features of the income statement in agriculture.

• Seasonal fluctuations: seasonal sales make it difficult to manage cash flow and expenses throughout the year. As mentioned above, the income statement is for reporting, not managing. We should know our yearly profit margin, but don’t forget about the seasonal fluctuations throughout the year!

• Confusing profit with cash: The income statement includes non-cash expenses like depreciation and amortization. While these expenses don't involve cash payments, they do impact profitability. Make sure to account for non-cash expenses when analyzing your financial performance.

• Cost structure: The cost structure of a farm can be quite different from other industries. For example, labor costs may be a larger proportion of total expenses than in other industries, and depreciation expenses may be higher due to the long-term nature of investments in land, buildings, and equipment.

• Complexity of inventory valuation: Ag is one of the few industries where you ‘grow’ your own inventory. Normally, inventory is valued at the price you paid for it. But when you grow it yourself, someone needs to assign a number to it. This is also highly dependent on when you value it. So take it with a grain of salt.

Quite a read… if you’re still with me, thanks! I hope you got something out of it!

Let me know if you have any questions or if there's anything else you'd like me to cover during the next edition of the Balance Sheet 🌷

Cheers,

Joey