Step 1: Determine Financial Health

by Duane Griffith, Montana State University

At harvest producers often enjoy a short pause after a long summer’s work. Machinery is stored for the winter and attentions are turned to livestock enterprises. Producers would not think about pulling their equipment into the fields for the next season without thoroughly reviewing its readiness and reconditioning it to assure good performance. The financial risks of downtime during critical production periods can be substantial too. Similarly, producers need to monitor and maintain their financial condition. Financial health refers to the well-being of a business as measured by adequate financial analysis. The first phase of the SRMP is strategic.

And the first step of the strategic process is to determine your financial health. Financial resources may be in better shape in some areas and less so in others. An example is strong net worth, but weak cash flow. In general, healthy performance in each area of interest leads to a healthy business that is better able to withstand the changes in the economy and business environment. The process of strategic and tactical financial analysis found in the SRMP can identify weak links and help prevent financial disaster.

Most producers prepare a balance sheet at the end of each year and a cash flow projection for the coming year. Some use the schedule F and tax returns as a proxy for an income statement. But this information does not provide an adequate picture of business financial position and performance and the impact the family structure has on the business’ financial health.

Preparing any financial information generates financial measures, but the results are suspect, at best, unless they are complete. Individual statements, like a cash flow, are useful in measuring historic cash flow or budgeting future cash needs, but management decisions based on a single statement are utilizing an incomplete picture of the operation’s financial position and performance.

There are five areas of financial health that should be monitored by all agricultural businesses: liquidity, solvency, repayment capacity, profitability, and financial efficiency. To get an accurate measure for all areas of financial health requires four financial statements: the balance sheet, a cash flow statement, an accrual adjusted income statement, and a statement of owner equity.

The information on the financial statements, as well as ratios and measures derived from the financial statements, are used to evaluate each of the five areas of financial health, and taken as a whole, the overall financial health of the business.

Preparing and reconciling all four of the financial statements is necessary, but understanding the flow of information between the financial statements and the reconciliation process is a critical first step in knowing how to use the information for complete financial position and performance analysis and tactical financial planning. The reconciliation process allows the business management team to get accurate measures of financial business position and performance. This is done by verifying how two values at different points in time are related.

Think about the process of reconciling a checkbook register after receiving the bank statement at the end of every month. This verifies the ending cash balance on successive bank statements, adjusting for deposits, checks, and other transactions that are not on the bank statement, or charges and other transactions made by the bank that are not in the check register.

The process accounts for all transactions by both the bank and the checking account owner to verify the amount of cash in the checking account. Reconciliation allows the checking account owner to see exactly how and why their account balance changed during the month.

Lack of adequate financial analysis implies an “any road will get you there” strategic planning process. Producers who do not know how they got to their current financial position will probably not be able to implement a plan for where they want to go.

Financial health is the ability of a business to produce a profit. If the business generates the optimal profit, it is financially healthy. That does not mean it is capable of supporting any desired family structure overlain on top of the business resource base. If the business resource base is small and generates a negative net farm income, it still does not mean that it is not being used at its economically optimal level. It may simply be that the cost of capital assets are large enough to prevent the resource base from earning a profit, even though the resource base is being used at an optimal level. In this instance financial health may be defined as earning as small a negative net farm income as possible with contributions from off farm sources supporting the business operation.

A clear definition of financial health is a moving target. It depends on many factors such as the size of the operation, the family structure involved, how the business is trying to support the family structure, and the particular stage family members might be in with respect to the business, to name a few. Financial health may be considered a very large net worth if Grandpa is transitioning out of the business and there is no one to take it over. If you are just getting started, then financial health might be the ability to generate enough net farm income to provide a family living and funds for expansion.

All of these situations point to a need to use a consistent and accurate approach to financial business position and performance analysis. Start with reconciled financial statements, develop business and family goals, complete tactical analysis on each alternative selected for evaluation from the strategic planning process, and monitor and measure the financial impact of implementing any particular alternative. If necessary, adjust.