The Income Statement

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Chapter 6 The Income Statement Its Analysis
2
Objectives

• Discuss purpose and use of an income statement
• Illustrate the structure and format of an income
  statement
• To define the sources and types of revenue and
  expenses that should be included on an income
  statement
• To show how profit, or net farm income, is
  computed from an income statement, and what it
  means and what it measures
• To analyze farm profitability by computing
  returns to assets and equity and by studying
  other measures of profitability

3
Income Statement

• Income Statement summary of revenues and
  expenses for a given accounting period
• Also called a Profit and Loss Statement
• FFSC prefers term Income Statement
• Measures the profit of a business
• 1st identify revenues and expenses

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Revenues

• Include revenue earned during the accounting
  period only
• Can be CASH or NONCASH
• NONCASH
• Ex inventory, accounts receivable, value of feed
  or livestock received in payment for custom work

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Revenues

• NOT ALL CASH RECEIPTS ARE REVENUES
• NOT gift or inheritance
• NOT a loan from the bank
• NOT non-farm income
• ONLY revenue from the production of agricultural
  commodities, services performed, and the gain or
  loss on the sale of assets used in that production

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Gain or Loss on Sale of Capital Assets

• Gain or loss on sale of capital assets
  difference between sales price and the cost of
  the capital asset for land and the difference
  between the selling price and the assets book
  value for depreciable assets like a truck.
• Gain or loss on sale of capital assets should be
  included in the revenue section

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Expenses

• Can be CASH or NONCASH
• NONCASH
• Ex depreciation, accounts payable, accrued
  interest, and other accrued expenses
• Include an adjustment for Prepaid Expenses
• FFCS recommends that income taxes are included on
  statement
• Will not include them in class due to the
  difficulty to estimate, particularly when there
  is off-farm income

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Expenses

• NOT EVERY EXPENDITURE OF CASH IS AN EXPENSE
• NOT cash expenditures for clothes, gifts
• NOT principle on loans, but would include
  interest expense
• ONLY business expenses for items required to
  produce agricultural commodities and services

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Income Statement Format

• Total Revenue
• -Total Expenses
• Net Farm Income from Operations
• /- Gain or Loss on Sale of Capital Assets
• NET FARM INCOME

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Accrual Adjustments to a Cash-Basis Income
Statement

• FFSC encourages use of Accrual Accounting
• However, a majority of farmers and ranchers use
  Cash Accounting which can be misleading and
  result in poor decisions
• FFSC recommends converting the Cash-Basis income
  statement to an Accrual-Adjusted Net Farm Income
  at the end of the year

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Net Farm Income Analysis

• If a business shows a Profit for the year, is it
  a Profitable business?
• Profitability concerned with the size of the
  profit relative to the size of the business, or
  the value of resources used to produce the profit
• In other words, a business can show a profit but
  have a poor profitability rating if this profit
  is small relative to the size of the business.
• Ex 2 farms with the same net farm income are not
  equally profitable if one used twice as much
  land, labor, or capital to produce that profit.

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Net Farm Income

• Net Farm Income amount by which revenues exceeds
  expenses, plus an gain or loss on the sale of
  capital assets
• Amount available to the operator for unpaid
  labor, management, and equity capital used to
  produce that net farm income
• Absolute dollar amount, thus it is difficult to
  assess profitability

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4 Methods to Measure Profitability

• 1.) RATE OF RETURN ON ASSETS
• 2.) RATE OF RETURN ON EQUITY
• 3.) OPERATING PROFIT MARGIN RATIO
• 4.) RETURN TO LABOR MANAGEMENT

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RATE OF RETURN ON ASSETS

• Also noted ROA or ROI
• Use a to compare with other farms
• ROA () Return to Assets()
  x 100
• Average Farm Asset Value()

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RATE OF RETURN ON ASSETS

• Numerator
• Net Farm Income from Operations
• Interest Expense
• - Opportunity Cost of Labor
• - Opportunity Cost of Management
• Return to Assets
• Denominator
• Average Farm Asset Value is the average of
  beginning and ending total asset values from the
  Balance Sheet

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RATE OF RETURN ON ASSETS

• EXAMPLE from Table 6-2 (page 98)

• Numerator
• Net Farm Income from Operations 46,800
• Interest Expense 29,500
• - Opportunity Cost of Labor -
  20,000
• - Opportunity Cost of Management - 5,000
• Return to Assets 51,300

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RATE OF RETURN ON ASSETS

• Denominator
• Average Farm Asset Value is the average of
  beginning and ending total asset values from the
  Balance Sheet
• If the value on Dec. 31, 2002 was 741,500 and
  was 710,000 on Jan.1, 2002, the Average Farm
  Asset Value would be 725,750

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RATE OF RETURN ON ASSETS
ROA () Return to Assets()
x 100 Average Farm Asset
Value() 51,300
7.07 725,750
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RATE OF RETURN ON EQUITY

• ROE is the return on the owners share of the
  capital invested
• NO ADJUSTMENT FOR INTEREST EXPENSE

ROE () Return on Equity ()
x 100 Average
Equity ()
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RATE OF RETURN ON EQUITY

• Numerator
• Net Farm Income from Operations
• - Opportunity Cost of Labor
• - Opportunity Cost of Management
• Return on Equity
• Denominator
• Average Equity is the average of beginning and
  ending market or cost basis equity for the year

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RATE OF RETURN ON EQUITY

• Numerator
• Net Farm Income from Operations 46,800
• - Opportunity Cost of Labor -
  20,000
• - Opportunity Cost of Management - 5,000
• Return on Equity 21,800
• Denominator
• Assume an average market basis of 361,320

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RATE OF RETURN ON EQUITY
ROE () Return on Equity()
x 100 Average
Equity() 21,800
6.03 361,320
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RATE OF RETURN ON EQUITY

• If ROA gt i then ROE gt ROA
• If ROA lt i then ROE lt ROA
• If ROA is greater than the interest rate paid on
  borrowed capital, this extra margin or return
  above interest cost accrues to equity capital

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OPERATING PROFIT MARGIN RATIO

• Higher value means more profit per dollar of
  revenue
• Operating Profit Margin Ratio Operating Profit
  x 100
• Total Revenue

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OPERATING PROFIT MARGIN RATIO

• Numerator
• Net Farm Income from Operations
• Interest Expense
• - Opportunity Cost of Labor
• - Opportunity Cost of Management
• Operating Profit
• Denominator
• Total Revenue

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OPERATING PROFIT MARGIN RATIO

• Numerator
• Net Farm Income from Operations 46,800
• Interest Expense 29,500
• - Opportunity Cost of Labor -
  20,000
• - Opportunity Cost of Management - 5,000
• Operating Profit 51,300
• Denominator
• Total Revenue 200,400

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OPERATING PROFIT MARGIN RATIO
Operating Profit Margin Ratio Operating Profit
x 100 Total Revenue
51,300
25.6
200,400 Meaning that on the
average, every dollar of revenue generates 25.6
cents after paying the operating expenses
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RETURN TO LABOR MANAGEMENT

• Dollar amount that represents the net farm income
  from operations to pay for operator labor and
  management after all capital is paid a return
  equal to its opportunity cost

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RETURN TO LABOR MANAGEMENT

• Net Farm Income from Operations
• Interest Expense
• - Opportunity Cost of all Capital
• Return to Labor and Management

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RETURN TO LABOR MANAGEMENT

• Net Farm Income from Operations
  46,800
• Interest Expense 29,500
• - Opportunity Cost of all Capital -
  58,060
• Return to Labor and Management
  18,240
• Assume OC capital is 8
• OC capital is 8(725,750) 58,060

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Change in Owner Equity

• Owner withdraws
• Increases in cash or other farm income
• Reduction in liabilities