Most of the work of a farm is in producing and marketing crops and livestock. But will this effort be economically viable? And what are the economic risks? These are questions that all farm businesses must answer regardless of whether they are for-profit or not-for-profit. To stay in business, the farm must be economically sustainable. To measure economic viability, this chapter will focus on two economic measurements – profit and cash flow.
Profit is the calculation of income minus expenses. Urban farms produce crops, livestock, and other products for sale which generates income. To produce these products, inputs are required such as seed, compost, feed, labor, machinery, structures, etc. Subtracting the expenses associated with these inputs from sales income results in profit.
Not-for-profit organizations need to understand their finances just as much as for-profit businesses do.
Not-for-profit organizations do make profits (or positive net income). The difference is that not-for-profit organizations do not distribute profit to the business owners or shareholders. Both for-profit companies and not-for-profit organizations can reinvest profit back into the business
The concepts and financial statements in this chapter are used by both for-profit and not-for-profit organizations. However, there are some differences in vocabulary and accounting logistics. Some of these differences will be pointed out throughout the text. For more financial management information specific to not-for-profit organizations, see the resource list at the end of this chapter.
Sometimes farmers focus on production and marketing and at the end of a season hope that there is a sufficient profit. However, good managers will set profit goals right along with production and marketing goals and focus on all three throughout the production season. How much profit do you want to make? Every farm business is different.
For some farm businesses, the owner/operator does not pay themselves a salary during the year as an expense. In this case, the profit must cover the owner/operator’s time and management. Some businesses want to make enough profit so they do not have to borrow money to grow the business – to buy more land, structures, machinery and other capital items. The profit must also cover loan principal payments which are not expenses. This is further explained in the section on cash flow.
Many small farms, including urban farms, are part time operations. Since the farmer has a full time job elsewhere to support themselves, they may have low expectations for farm profit or for the farm to give them a reasonable wage for their time. But “farming for nothing” soon discourages people.
So considering these and other issues, a farmer should set goals for how much profit they want to make right from the beginning. Then, meeting this goal is dependent on the two factors - income and expenses.
Income is dependent on the amount of each agricultural product that you plan to produce and sell, as well as the market price for those products. So as you plan production and marketing you should also be setting your income goals. A good systemized approach for doing this is outlined in the book “The Organic Farmer’s Business Handbook” by Richard Wiswall. Farmers are encouraged to get this book which goes into much more detail than can be covered in this chapter.
Restricted funds: a special kind of income
Sometime income comes with restrictions on how it may be used. For example, most grants are awarded for specific purposes (specified in the grant proposal). If a grant is administered on a reimbursement basis, you will need to make the approved expenditures and then submit records of the expense to the granting agency for reimbursement. If the grant funds are entrusted to you, at the end of the grant period you will likely need to return any funds that cannot be shown to have been spent on the approved expenses. For examples of how financial statements can be modified to keep track of restricted and non-restricted funds, see the additional resources at the end of this chapter.
The other factor that affects profit goals is expenses. As mentioned before, expenses are associated with the inputs required for producing agricultural products. Income minus expenses equals profit. Expenses can be described in different ways but here we will describe three types of expenses – variable/operating, fixed/overhead, and depreciation.
Variable/Operating expenses are directly tied to producing crops and livestock and usually increase or decrease proportionately to the increase or decrease in production. For example, if you decide to produce more crops, you will need to purchase more seed, fertilizer, and other crop inputs. If you produce more livestock, you will need to purchase more feed. So as you set your production goals, you should calculate the levels of inputs you need to purchase and these expenses will have to be subtracted from income to calculate profit.
You incur some fixed/overhead expenses that are not directly associated with the amount of agricultural products you produce. For example, expenses like property taxes, insurance, loan interest, utilities, and office supplies do not vary with the amount of crops and livestock produced. These are often fixed at a certain amount.
Some expenses may be both operating and overhead. For example, if you hire labor on an hourly basis and it fluctuates according to needs of production, then it is a variable/operating expense. If you have salaried employees that get a fixed wage, then it is a fixed/overhead expense.
Producing crops and livestock often requires machinery, structures, and other capital items which add to the expenses of the farm. Since these items last for several years, you do not subtract the entire cost for use of equipment and structures in the year they are purchased. Instead, you depreciate their value; that is, you prorate their cost over the useful life of the machinery and structures so you charge only part of the cost against each year's income. Sometimes this is referred to as a “non-cash” expense since you do not expend cash for the prorated depreciation cost, only for the purchase. Some farmers disregard depreciation in calculating profit since it is a non-cash cost. But doing so overstates the amount of profit. The profit looks good until you have to replace a worn out tractor or high tunnel. Then you realized the profit wasn’t as good as it looked. Deducting depreciation each year helps you calculate the true profit.
When you subtract out variable/operating, fixed/overhead, and depreciation expenses from the income, the result is profit. With the profit, you can pay yourself (If you haven’t already expensed a salary for yourself), grow the business, and pay down debt principal.
We have discussed profits in relation to the whole farm. Since you likely produce several agricultural products, you can view each different crop or livestock enterprise as a separate profit center so you can determine which enterprises contribute more to the overall profit of the farm and which ones contribute less. You can then decide what to do with the less profitable enterprises. Calculating profits for individual enterprises is similar to calculating profits for the entire farm, with one difference. In your calculations, you include only income and expenses pertaining to the individual enterprise. This process is called enterprise budgeting. Methods for enterprise budgeting are also included in Richard Wiswall’s book mentioned earlier.
To calculate your farm profit from the past year or project the profit for the coming year, you summarize income and expenses on an income statement or projected income statement, sometime called profit-and-loss statement or statement of activities. The income statement should cover a given accounting period, usually the calendar production year.
Income statements should be constructed for both historical analysis of farm profits and projecting future profits. The past year is always a good baseline for projecting profits for the next year. Figure 1 illustrates an income statement for an example farm. It records the historical income, expenses, and profit for the past year and projections for the coming year.
The example farm is a part time small urban farm where the owner works nights and weekends on a 10,000 square foot plot (a little smaller than ¼ acre) in the city. The plot is intensely cultivated with a variety of vegetables produced in high tunnels and raised beds early spring through the summer peak period and into the late fall. Much of the land is double or triple cropped during the year. The produce is marketed through a CSA, on-farm sales, and minor sales to local restaurants.
Income - The income from three main marketing channels for last year is listed in the income sections – 10 member CSA ($600x10=$6,000), on-farm sales ($4,000), and minor sales to local restaurants ($3,000). Last year this farm brought in a total income of $13,000.
Expenses - The expense section first lists the variable/operating expenses of seed, fertilizer and compost, pest management supplies, and boxes. Next comes the fixed/overhead expenses of supplies, repairs and maintenance, insurance, utilities, marketing, office supplies, other expenses, and interest.
The owner/operator provides all of the labor for managing and working the farm and values this labor at $5,000. It is important for owner/operators to “pay themselves” for the work that they do. This can be accounted for by including it in the expenses like in this example. If a farm also hires other labor, this would be included on an additional line.
Depreciation is include as an expense for prorated cost of the high tunnel, equipment, and tools as discussed earlier. Total expenses last year were $12,000.
Profit - Subtracting the $12,000 expenses from the income of $13,000 results in a profit of $1,000. Remember that the owner has already paid themselves $5,000 for their management and labor so this $1,000 can be used to pay principal payments on the loan and for growing the business.
The farmer has projected the income statement for the coming year. Income is projected to increase through adding 3 more CSA subscriptions and additional on-farm market sales. Increasing income will also increase some expenses because of the additional production. Profit is projected to increase from $1,000 to $2,000.
An income statement is the one financial form that is required by the Internal Revenue Services for all farm businesses. It is used to calculate profit for tax purposes. The IRS version of an income statement is Schedule F (Form 1040) Profit or Loss From Farming (Figure 2). Note that this form is subject to change from year to year. You can access the up to date form at https://www.irs.gov/
Notice that the two main sections of the Schedule F are Part I Farm income and Part II Farm Expenses. In Part I there are lines for various types of farm income. Most farm income is recorded on line 2, “Sales of livestock, produce, grains, and other products you raised. Part II is used for recording farm expenses. Notice that variable/operating expenses and fixed/overhead expenses are intermixed on the form and that depreciation is on line 14. The IRS specifies methods for calculating depreciation which are often used by farmers for calculating depreciation for management purposes. To understand more about Schedule F and about tax depreciation calculation, refer to IRS publication 225, Farmer’s Tax Guide (IRS 2018).
Generating profits should influence most decisions as a farm manager. Many things affect the level of profit. This, in turn, determines remuneration for the operator’s management & labor, the growth potential of the farm business, and the ability to pay off debt. A good farm manager should ask himself/herself the following questions often.
There is no one clear path to improving profits. Rather, profitability is a state of mind in which a farm manager carefully controls every aspect of the operation to make the most profitable and economic use of the resources available to the farm business.
Another important economic measurement is cash flow. Cash flow is closely related to profitability but there are significant differences. While profit is concerned with the income versus expenses for a production period such as a calendar year, cash flow is concerned about the ending cash balance on hand at given points of time during the production period, the “checkbook balance” so to speak. Cash flow also considers cash inflows and outflows not include in calculating profit. Assessing cash flow can help you plan to have cash on hand at any time when you need it to both pay for seasonal expenses and to weather unexpected expenses and emergencies.
Cash flow usually covers the same production period as the income statement but cash flow is almost always broken down into smaller time periods such as a quarter or a month. For each period, the cash flowing out of the business is subtracted from the cash flowing into the business to calculate the ending cash balance – the amount of money on hand at the end of each period. If the owner/operator is doing a business plan for the new enterprise, then the cash flow budget is part of the business plan. Many new farms fail, not because the new idea is bad or because profit is insufficient in the long term, but because there is not sufficient cash in the early stages of the project.
A cash flow budget does not determine if the business is profitable. An income statement is required to determine profitability. There is a difference between income & expenses and cash inflows & outflows. Figure 3 contrasts these differences. In the following paragraphs, numbers in parentheses refer to lines in Figure 3.
In calculating profit and cash flow, both include income(2) and expenses(6). Since income and expenses are the major financial transactions of a business, there are great similarities in the two calculations. But there are also significant differences.
Cash flow does not consider depreciation(11). It is not a cash flow. You do not “write out a check” for it. It does not affect the ending cash balance.
However, cash flow considers closely related items – capital purchases(7) and capital sales(3), things that last more than one year. If you buy machinery or build structures, you don’t expense the entire purchase price in the year you buy them, you depreciate them(11). However, you must have the cash to purchase these capital items. So capital purchases(7) are included in the cash flow. If you sell used machinery or other capital item, that is not income to include in calculating profit. You produce crops and livestock. You do not produce capital items and you are not in business to sell them. But when you sell a used capital item, cash flows into the business(3).
If the farm needs to buy a piece of equipment this year like a walk-behind tiller, the price of the tiller is included in the cash flow(7) because the entire cost has got to come from somewhere. If you don’t have the money, then you may borrow money(4) to buy the tiller. This is not income like selling crops. When you are borrowing money you have to pay it back(8). When you pay the principal back, it is not like buying seed or fertilizer. You are trading cash for reduced debt. So loan principal payments(8) are only included in the cash flow, not in calculating profit. Interest on loans is an expense and is included in the expenses(6) of calculating profit and cash flow.
Sometimes money flows into the business from other sources(5) For example, you may invest some of your personal savings or wages from an off-farm job in the farm. This inflow is not the same as income for selling agricultural products so it is not included in calculating profit. But, it is a cash inflow to be included in calculating cash flow(5). Sometimes you will withdraw money from the business (9) such as giving yourself a dividend from the profit. This is not the same as buying inputs so it is not included in calculating profit but it is included in the cash flow as a withdrawal from the business (9).
In summarizing cash flow, the yearly production period is usually broken down into quarters or months. For each of these periods, you begin with the beginning cash balance(1) You add income(2) and subtract expenses(6). You add capital sales(3) and subtract capital purchases(7). You add loan receipts(4) and subtract loan principal payments(8). You add off-farm income(5) and subtract withdrawals from the business(9). These calculations result in the ending cash balance for the period(10).
Figure 4 illustrates the cash flow for the farm in the previous example. The income statement is also included to contrast the similarities and the differences in these two financial statements. Compare these financial statements with the formulas in figure 3.
The second column of the cash flow shows the cash flow for last year. At the beginning of the year there was a cash balance of $500. The sales income and production expenses are the same as they are on the income statement. But notice that depreciation for the high tunnel and equipment is not included in the cash flow because it is a non-cash allocation of these capital purchases. Notice also that there are loan principal payments for a loan that was received to purchase the high tunnel two years ago.
At the end of the year, the cash balance was $1,400, $900 more than at the beginning of the year. This does not say anything about the profitability of the farm. The income statement shows that last year’s profits were $1,000. However, if a business is profitable, it is more likely to have a positive cash flow.
The farm’s cash flow for each quarter of the coming year and the total for the year is projected in columns 3-7. The cash flow reflects the increase in income and expenses. Notice that the income and expenses vary across each quarter. For example, the CSA subscription payments are received in the first quarter while most of the on-farm market sales are in the second and third quarters. Most of the seed, fertilizer and compost, and pest management supplies are incurred during the second quarter while other expenses are incurred evenly across the quarters. In the first quarter a new tiller is going to be purchased for $500. The owner also plans on increasing their bonus at the end of the year by $500. Loan principal payments are decreasing since the loan balance has decreased in this amortized loan. The cash flow is projected at $3,300 at the end of the year.
The cash flow is one of the most useful tools a farm manager has for managing the business. The reason that a cash flow budget is useful is because it forces you to think through all production and marketing aspects of your business. As mentioned before, many businesses fail, not because the idea is bad or because long term profit is insufficient, but because of short term cash flow problems. In developing cash flow, you have to estimate the quantity of products you will sell and the prices that you will receive. You have to estimate when the products will be sold. To produce these estimates you will need to develop a marketing plan. You have to understand the production process completely in order to project costs. You have to understand the time-line for production. You have to know how much land, labor, machinery, and raw materials you will need and when you will need them. You have to know the prices for all of these inputs. You will also have to estimate storage and transportation costs to get your products to the market. You will have to estimate the timing of all inflows and outflows through the year. This tool helps you to understand the short term cash flow problems that often accompany new activities.
The cash flow will help you understand if you need to borrow money, how much money you will need to borrow, and when you can pay the loan back. A cash flow budget is a useful tool for explaining the financial implications of your enterprises to a lender from which you are applying for a loan. Most bankers or lenders will require a cash flow budget as part of a business plan.
Sometimes you may employ a financial advisor to help you complete the cash flow budget. The main purpose of a financial advisor is to help you lay out the cash flow budget and to help you think through the business. But it is important that you understand all of the numbers in the cash flow budget and how they were calculated because you are ultimately responsible for the success or failure of the business. If the business fails, it is likely because you did not do a realistic cash flow budget.
Computer spreadsheets such as Microsoft Excel are used to make the cash flow calculations easier to do. There are generic spreadsheet templates that can be adapted to your business. There are blank income statement and cash flow forms at the end of this chapter (Figures 5 and 6).
Most farms at one time or another experience cash flow problems. The cash flow budget is one of the best ways to pinpoint these problems, but it will not solve cash flow problems, rather it reveals symptoms of problems. Measures can then be taken to deal with the actual problems. The following are some methods for dealing with cash flow problems.
Improve profitability - Cash flow problems may be the symptom of the greater problem of low profitability. In approaching cash flow problems, first analyze profitability. Increasing profitability is often the best way to remedy cash flow problems. Once the farm is profitable, you can then concentrate on cash flow problems. However, in adopting strategies to remedy cash flow problems, be sure these strategies do not adversely affect profitability. For example, borrowing money to solve a cash flow problem will result in additional interest expense that can hurt profitability. Treating cash flow problems at the expense of profitability is a short term remedy that may have detrimental long term effects.
Prevent the problem - It is important to identify cash flow problems before they occur. This "preventative medicine" will allow time to alter plans and remedy the problems by timing cash inflows and cash outflows. It's useful for determining the best method to maintain cash reserve. There is no one strategy that will work at all times. Rather, a combination of strategies is the basis for solving cash flow problems.
Consider alternative enterprises - Carefully look at the combination of enterprises on the farm. Perhaps another enterprise would increase cash flow while at the same time maintaining profitability. For example, putting a greater focus on spring vegetables may generate cash flow during a time when there are a lot of crop inputs to purchase. Value-added products and agritourism are other ways to create additional enterprises based on existing resources.
Managing expenditures - A very effective way to improve cash flow is through cost control, for example, postponing capital purchases. You should frequently check to see if levels of inputs are economical. Are the best seeds and seeding rates being used? Is fertilization at an economically optimal level or are you applying too much fertilizer? Can commercial fertilizer be reduced through better management of compost or livestock wastes? Would an investment in mulch pay for itself in reduced time spent weeding? Can labor be better utilized to decrease expensive capital outlays? Is there better machinery that would improve labor efficiency? Can machinery costs be cut through reduced tillage methods? Can repair bills be reduced through on-farm repairs? Can interest costs be lowered through better loan rates or timing of loans? Every cost should be scrutinized to determine if it can be reduced without adversely affecting profitability.
Improving marketing plans - Improving farm profitability should be the main goal in formulating a marketing plan. As mentioned before, poor marketing is one of the main reason for business failure.
Leasing or renting - The down payments and loan payments associated with purchasing land, buildings and machinery sometimes put a heavy burden on cash flow. Leasing or rental payments may be considerably lower and will free cash that is needed for other obligations. However, assess the impact of these leasing and rental arrangements on profitability of the farm operation.
Reduce business withdrawals - If you are withdrawing profits from this business for personal use, carefully review the amount you are withdrawing. Record all personal expenditures. Many individuals are surprised by how much they spend for personal living expenses. Distinguish between necessities and wants. Postpone unneeded personal expenditures. Base personal withdrawals on the performance of the farm business and/or off farm income. Be realistic in determining the amount of personal withdrawals the farm can support.
Off-farm employment - Rely more on part-time or full-time employment off the farm. Off-farm employment may also include health care insurance and other benefits. Carefully consider any additional expenses related to off-farm employment such as transportation, clothing, child care, etc.
Refinancing - Cash flow problems are sometimes caused by too much short term debt on the farm. For example, some farmers use credit cards or short term operating loans to finance long term assets. Normally credit cards or operating loans are used to purchase variable inputs such as seed, transplants, feed, fertilizer, compost, row covers, etc. Every effort should be made to pay off the credit card or loan balances as the farm produce is sold to minimize interest expenses. Credit cards or operating loans should not be used for long term assets such as equipment or structures because the receipts from one production period cannot be expected to cover the costs of assets that last several production periods. The idea of self-liquidating loans suggests that a proper financing program for loans would synchronize the input's life and pattern of earnings with the length of repayment schedule on the loan used to obtain the input. That is the reason that farm equipment is financed for five to seven years. Financing it for a shorter period may cause cash flow problems. If adverse weather conditions result in insufficient receipts to cover the operating loan, rolling this loan over to the next year may cause cash flow problems. Perhaps the loan should be refinanced over a longer period so the cash shortfall can be absorbed over several production periods. Refinancing can effectively deal with cash flow problems but sometimes it may just be buying time. If the farm is not profitable, refinancing is a warning flag to indicate the problem is being prolonged.
Liquidating assets - Selling capital assets is usually a more drastic measure for dealing with cash flow problems. However, it may be justified. Sell unprofitable assets first. Excessive personal assets, unused machinery, unproductive land, etc., are good candidates. Consider downsizing the operation through selling off excess capital, but only after doing an in depth long term financial analysis of the impact of these corrective actions. Do not sell assets without discussing it with creditors who have a lien on those assets.
Maintaining credit reserves - One should always maintain a credit reserve. If a farmer borrows to the limit, bills will accumulate and creditors will line up at the door. When experiencing cash flow problems let creditors know what is being done to solve the problems. Avoiding creditors may just aggravate the problem.
Maintain or improve credit scores - Check your credit score with the major credit bureaus to see if there are any weaknesses that will make it more difficult to get loans from lenders who rely upon these scores to make their loan decisions. Over time, it is possible to improve credit scores through good credit management. This will increase borrowing capacity.
Grants, fundraising, and recruiting investors - A grant or investment will not make an unprofitable organization profitable. Before applying for a grant or recruiting investors, start by working through the financial statements in this chapter. Ask yourself the following questions:
Any funder, whether a granting agency or a loan officer or an investor, will want to know how their funds will be used, and what their return will be on their investment. Loan officers and investors will expect their investment to be paid back with interest. Granting agencies will expect their funds to be used to make measurable impact on the issues specified in the grant Request for Applications (RFA) or Request for Proposals (RFP). In general, granting agencies like to fund new, exciting projects. Grants usually cannot be used to pay for annual operating expenses, and almost no grants allow for capital purchases such as buildings, land, or large pieces of equipment.
A manager of a farm needs a good record keeping system to analyze profit and cash flow. Many businesses will contract out their accounting to an accounting firm. These firms typically use generally accepted accounting principles and produce standardized financial statements including the income statement and statement of cash flow. However, it is too often the case that the main reason a farm hires an accounting firm is to file tax reports. While this is an important job of the accountant, managers who fail to use financial statements produced by the accountant may make poor financial decisions. Many small farms do not generate sufficient income to hire an accountant or bookkeeping. If this is your situation, then you must do the record keeping yourself. You can then turn the books over to the accountant at the end of the year to have tax reports filed. Some farmers even do their own tax reports to save money.
All income & expenses and inflows & outflows need to be recorded in a bookkeeping system. Farmers should set aside time each week and sometimes daily to do this. Each transaction should be recorded including the date, the amount, and the type of transaction according to the income statement and cash flow categories. Sometimes the process can be cumbersome. Richard Wiswall’s book mentioned earlier provides ideas on how to simplify the process.
Which computer accounting program should I use?
Some farmers record incomes and expenses in a ledger book. However, many farmers now have computers that simplify the bookkeeping. Even inexpensive computer tablets have the capacity to do record keeping. Computer accounting programs range from inexpensive to expensive and from simple to use to complex systems requiring considerable knowledge of generally accepted accounting principles. Most computer programs generate basic financial statements but some also offer advanced analysis and planning tools. The right program for the business depends upon all the factors mentioned in this chapter and the accounting background of those in the business responsible for bookkeeping. QuickBooks and Quicken are two generic computer programs that many farmers use for their bookkeeping. Some farmers will consult with an accountant in determining the best program for the business. Incomplete records will result in a poor financial analysis of the farm. Keep accounting records up to date throughout the year through routine record keeping daily or weekly.
What accounting period should be used?
An accounting period summarizes revenue and expenses for a given period of time. It can be a calendar year or a fiscal year. A calendar year starts on January 1 and ends on December 31. The year can be further broken into quarterly or monthly periods. The fiscal year lasts for 12 months but begins on a day other that January 1. Fiscal accounting periods can also be broken into quarterly or monthly periods. As a rule, the accounting period follows the production cycle of the major enterprises of the business. For example, most crop and some livestock producers follow a calendar year because the production cycles of these enterprises begin and end during the calendar year and during the winter, the business activity slows somewhat. Farms or businesses should choose an accounting period which best accommodates their production cycle. Most will choose a calendar year.
Understand profit and cash flow is paramount to the success of the business. Profitability measures the amount of farm income generated from sales of goods and services over and above the expenses required to generate that income. An income statement is used to analyze profitability. A farm must generate a profit to survive in the long run. In calculating profit, farm managers often leave out expenses related to the value of their labor, management and investment. Not only must farm income cover the direct expenses of the business, but they also must cover these resources that are sometimes taken for granted. Cash flow relates the ability to meet cash obligations without disrupting the normal operation of the farm. It deals with the timing of cash inflows to meet the cash outflows. Cash receipts from crops and livestock sold rarely coincide with cash expenditures. A cash flow budget is used to analyze the timing of cash inflows and outflows. Most farms have periods when they are short of cash to pay bills. A credit reserve for borrowing money through these periods is needed to maintain the cash flow. Likewise, this money will have to be paid back. Cash flow planning helps to monitor these inflows and outflows. Profit and cash flow are both areas of concern for the farm manager. The operation that is strong in one of these areas is often strong in the other areas as well. Profitability drives cash flow. A profitable farm will usually overcome cash flow in the long run, while an unprofitable farm will nearly always develop cash flow problems. People often confuse profitability with cash flow and vice versa. Some farm managers who experience cash flow problems think that their farm is not generating any profit. Likewise, some farm managers who have a positive cash flow have the impression that their operation is profitable. Neither of these assumptions is necessarily true. You cannot equate profits with cash flow.
