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Financial Statements

Income Statement and Cash Flow

Defined

Agricultural Income Statement and Cash Flow Projection Income Statement


Net income, or profit, is one of the most important factors determining the long-run viability of a business operation. Profits are needed to support your living expenses, build equity, repay (service) debt, provide capital for expansion, and prepare for the future. In contrast to a balance sheet, which shows financial position at a given point in time, an income statement measures business revenues and expenses over an accounting period. Our discussion will focus on assessing income on a family farm operation with both farm and non-farm sources of income. All agricultural income statements include two categories: revenues and expenses. However, there are two different types of income statements that may be prepared, distinguished by the way revenues and expenses are recorded. A cash income statement measures revenues only when received and expenses only when paid. An accrual income statement measures revenues when generated and expenses when incurred, whether or not cash actually changes hands. The cash income statement is the easiest to prepare and is the most common form used by traditional and lifestyle agricultural businesses. The Schedule F tax form is typically used as a cash income statement. In many cases, it can be used effectively in analyzing profitability if three to five years of information is provided, and the business is in a stable operating mode with no major adjustments. The use of a cash income statement rests on the assumption that the shifting of income and expenses will even out over time. Lets look at two examples of how cash and accrual accounting methods differ: Revenue example Mr. Hokie sells hay in the amount of $500 to a neighbor on December 29th of year X. The neighbor doesnt pay Mr. Hokie until January 10th of year Y. Using the accrual method, Mr. Hokie would recognize $500 of income in year X. However, using the cash method, Mr. Hokie wouldnt recognize the revenue until he received cash in year Y. Expense Example Mr. Hokie purchases $2,000 worth of fertilizer with cash on December 28th of year X. Mr. Hokie does not use the fertilizer on his operation until March of year Y. Technically, the fertilizer is not an expense to Mr. Hokie until it is applied to his fields. However, using a cash-based income statement, Mr. Hokie would report $2,000 of fertilizer expense for year X. Under the accrual method, the expense would appear on the year Y income statement. One can see that the cash method of income accounting has its shortfalls by improperly timing revenues and expenses. However, as stated earlier, this is the most common and easiest method of reporting income. Therefore we will focus our practical discussion on cash accounting, using the Federal Income Tax Schedule F as a proxy for the farm income statement along with accompanying individual tax forms. The basic equation for the cash income statement is:
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Financial Statements

Income Statement and Cash Flow

Defined

Income Expenses = Net Profit (Loss) Revenues and expenses can come from a variety of sources in an agricultural business. However, the income statement only reports business-related revenues; it does not include non-farm income! Categories of revenues that are included on the cash income statement include: Cash revenues from the sale of livestock or other items bought for resale (revenues are reported net of the purchase cost or other basis) Cash revenues from the sale of livestock, produce, grains, and other products raised Distributions from cooperatives and agricultural program payments and other government programs Crop insurance proceeds Income from custom hire work Other sources of farm income

Expense items included on the income statement vary with the type of operation but include all business-related operating expenses, interest, and depreciation. Depreciation, although not a cash expense, is included on both the cash and accrual income statements. It is a way of spreading the cost of capital purchases over their useful life. The simplest method of depreciation is the straight-line method [(Purchase Price Salvage Value) / Years of Useful Life]. Accelerated depreciation is sometimes used for tax purposes. If this is the case, it should be noted that accelerated depreciation is being used, because it will distort profitability. Please note that family living expenses are not included on the income statement. Likewise, loan principal payments are also not included. Repaying the principal on a loan is not an expense; rather it is a repayment of an obligation. Depreciation serves as the method of expensing the cost of capital items such as equipment, breeding livestock, structures, and improvements. On the Schedule F, expenses are subtracted from income to arrive at net farm profit or loss. The two main uses of this profit figure are determining self-employment taxes and as an input on the Federal Individual Income Tax Return (Form 1040). Self-employment tax is a Social Security and Medicare tax for individuals who work for themselves. It is similar to the Social Security and Medicare tax withheld from the pay of wage earners. The self-employment tax is higher than that paid by wage earners, because the employer covers half of the tax for those who are not self-employed. Self-employment tax is paid in addition to the regular income tax when a return is filed. One-half of the selfemployment tax can be deducted as an adjustment to gross income. The IRS offers several options for calculating the self-employment tax. However, a good estimate is the following formula: Self Employment Tax = (Net Farm Income) x (.9235) x (15.3%)

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Financial Statements

Income Statement and Cash Flow

Defined

After net farm income and self-employment taxes have been determined, the individual income tax return can then be completed. The attached summary of the procedure for determining federal taxes provides a basic guide for understanding how taxes are calculated. The example case study at the end of this document illustrates the preparation of the Schedule F and Form 1040.

Cash Flow Projection


The income statement may indicate that a business is profitable, however profitability does not always equate into positive cash flow. Agricultural producers and lenders are often equally, if not more, interested in the future performance of a business in terms of cash flow. For this reason, a cash flow projection is a valuable financial tool. A cash flow projection summarizes cash inflows and outflows over a given period. A cash flow can be prepared for the business, individual, or a consolidation similar to the balance sheet and income statement. The cash flow projection is useful for determining: The need for operating lines of credit to cover cash flow deficits Periods of excess cash when funds could be placed in income-earning assets such as money markets or a future payment fund The need for changes in marketing or expenditure plans The appropriateness of loan repayment and financing plans The cash flow feasibility of a new investment The cash flow in a transition year before the operation is fully engaged

The cash flow projection can also be useful for preparing projected income statements and balance sheets. The preparation of a cash flow statement follows the following accounting identity: Beginning Cash Balance + Cash Inflows Cash Outflows = Ending Cash Balance The format of a cash flow projection can take on different forms, but there are three basic components: cash inflows, cash outflows, and operating finance activities. The cash inflow section lists receipts from farm and non-farm activities, divided into categories that are relevant for the type of business being examined. The cash outflow section includes a detailed listing of all cash expenses, principal and interest payments on term debt, family living withdrawals, tax payments and withholdings, and any planned investment activities. Note that depreciation does not appear on the cash flow projection because it is not a cash expense and will not impact cash flow. The operating finance activities section outlines the net cash flows for each quarter along with the short-term borrowing needs, interest accrued, and repayment of the line of credit. Rather than preparing cash flow projections for multiple years, a one-year projection can be combined with sensitivity tests to examine price, cost, and related impacts. Questions can be asked such as: How would cash flow be affected if crop prices were 50 cents lower
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Financial Statements

Income Statement and Cash Flow

Defined

than expected? or What is the impact of a 10% increase in fertilizer costs? These tests help identify how sensitive an operation or projected change is to changes in the market environment. It is important to remember that a cash flow projection is only as good as the assumptions and information used to prepare it. The following example case illustrates the preparation of the cash flow projection.

Example:
Nick Hokie operates a stocker cattle and beef cow-calf operation in southwestern Virginia. His wife, Polly, is a managing partner for a veterinary clinic in the region with a $35,000 annual salary. Nick and Polly are both graduates of Virginia Tech and are 35 years old. The Hokies have two sons, a 10-year-old Al and 8-year-old Clark. The Hokies still rent the home in which they are currently living. Nick rents Pollys grandparents farm, including the machinery. He also owns a 300-acre farm. Nick purchases 400 lb. cattle in the spring each year and then sells them as 700-800 lb. cattle in the fall. He usually has about 120 head. In addition, Nick has about 75 breeding cows and 3 bulls. He raises calves for sale at 500-600 lbs. Nick also sells hay in the winter and occasionally sells high-priced bulls. One of Nick and Pollys New Years resolutions was to get a better grasp on their financial situation. They have already completed a current balance sheet. They would now like a cash flow projection for the coming year, as well as a projected income assessment using the federal income tax format. Below is some key data from the balance sheet that you may need for the cash flow and income statement.

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Financial Statements

Income Statement and Cash Flow $8,000

Defined

Cash Balance on January 1, Year X

Farm Loan Annual Payment: $18,609 each December 1st $126,637 x .09 = $11,397 interest $18,609 - $11,397 = $7,212 principal within 1 year $126,637 - $7,212 = $119,425principal beyond 1 year $11,397 / 12 x 1 = $950 accrued interest Cattle Loan Annual Payment: $13,735 x .10 = $1,374 $7,914 - $1,374 = $6,540 $13,735 - $6,540 = $7,195 $1,374 / 12 x 4 = $458 $7,914 each September 1st interest principal within 1 year principal beyond 1 year accrued interest

Tractor Loan Quarterly Payments: $2,269 on 2/1, 5/1, 8/1, 11/1 $18,524 x .08 = $1,482 interest 4 x ($2,269) - $1,482 = $7,594 principal within 1 year $18,524 - $7,594 = $10,930 principal beyond 1 year $1,482 / 12 x 2 = $247 accrued interest Attached is a summary of cash revenues and expenses and other information you will need to complete the cash flow projection and income analysis. Use this data as well as that from the balance to complete the attached forms. The Hokies have a $20,000 operating line of credit with Farm Credit to help cover cash deficits that may occur during the year. The interest rate is 10% and the current balance is zero. The Hokies like to maintain a minimum $1,000 cash balance. The Hokies choose standard deductions on the federal income tax return, rather than itemizing deductions.

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Financial Statements

Income Statement and Cash Flow


Summary of Financial Transactions Nick and Polly Hokie For Year X

Defined

Revenue/Inflow Sale of Cattle (Purchased for resale) Sale of Calves (Raised) Sale of Hay (Raised) Sale of Cull Cows (Raised) Sale of Bulls (Raised) Non-Farm Income Interest Earned (Non-Farm) Expense/Outflow Accounting and Record Keeping Business Trip Expenses Custom Hire Depreciation Feed Fertilizer Freight & Trucking Fuel Insurance Labor (Hired) Miscellaneous Property Taxes Purchased Cattle Rent and Lease Repairs and Fencing Seeds and Plants Supplies Utlilities Family Living Expenses Federal Income Taxes Withheld FICA and State Income Tax Withheld Past Year's SE and Income Taxes IRA Contribution Interest on Loans Principal on Loans Self Employment Tax Calculation: Net Farm Income x 0.9235 x 15.3%

Quarter I

Quarter II

Quarter III $13,500

$4,000 $3,600 $8,750

$8,750

$8,750

Quarter IV $57,525 $13,500 $3,575 $2,400 $1,800 $8,750

Total $57,525 $27,000 $7,575 $2,400 $5,400 $35,000 $1,200 Total $300 $300 $500 $14,750 $1,500 $5,500 $500 $1,200 $2,640 $500 $400 $2,500 $33,600 $4,000 $2,000 $800 $500 $1,100 $28,000 $3,720 $3,600 $1,850 $2,000 ? ?

Quarter I $150 $75 $125 $750 $125 $300

Quarter II $50 $75 $125

Quarter III $50 $75 $125

Quarter IV $50 $75 $125 $750 $3,000 $125 $300 $1,320 $100 $1,250

$2,500 $125 $300 $1,320 $100 $1,250 $33,600 $500 $125 $250 $6,500 $930 $900

$125 $300 $500 $100

$100

$4,000 $500 $800 $125 $300 $6,500 $930 $900 $1,850 ? ? ? ?

$500 $125 $250 $6,500 $930 $900

$500 $125 $300 $8,500 $930 $900 $2,000

? ?

? ?

(For Year X, won't be paid until Year Y)

2005 Federal Income Tax Rate Schedule (Married, Filing Jointly)


Over $14,600 $59,400 $119,950 $182,800 $326,450 Less than $14,600 $59,400 $119,950 $182,800 $326,450 Rate 10% 15% 25% 28% 33% 35%

Standard Deductions for married, filing jointly = $10,000 + $3,200/dependent (including yourself & your spouse)

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