Analyzing a Farm Income Statement*

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Analyzing a Farm Income Statement*

William Edwards Revised March 2006
Iowa State Extension Economist
478C Heady
515.294.6161
wedwards@iastate.edu

Net farm income is an important measure of the performance of the farm business. Taken by itself, however, it leaves some important questions unanswered.

Did your value-added farm earn enough to pay a fair return to the labor it employed, as well as to management? What rate of return did you earn on your total investment? Or on your net worth? The worksheet at the end of this publication shows how to compute answers to these questions.

First, a few additional pieces of information are needed. The beginning and ending market values of your total farm assets, long-term farm assets, and net worth can be taken from your net worth statements. Accrual net farm income and interest expense come from the front side of the Net Farm Income Statement. The amount of unpaid labor used on the farm and the opportunity costs for capital and labor must be estimated.

The opportunity cost of capital is the return that could have been generated from the various assets if you had not used them in your own farming operation. For example, you could have received a cash rental return from you farmland if it was not used in your business. Machinery and equipment can be sold and the money invested elsewhere.

The fairest comparison is probably the average rates of returns earned by other farmers on similar assets. Studies have shown that average earnings have been around 3 to 4 percent on long-term farm assets, and have fluctuated from 6 to 10 percent for other farm assets during the last decade. Multiply each rate by the corresponding beginning asset value.

You will have to estimate the months of labor used in the farm business. Generally, 12 months of operator labor are assumed unless the operator is employed off the farm much of the time. A two operator farm business (such as a partnership) could have 24 months of operator labor. Family members who help with chores plus some fieldwork during peak rush seasons probably contribute the equivalent of one or two months of labor per year.

The opportunity cost of labor is the income that could have been generated if labor had been employed elsewhere in comparable work. Typical farm labor rates in your area are probably the best estimate. You may want to use different rates for different family members. Multiply each rate by the quantity of labor used.

Rate of return to equity capital
(net worth)
Subtract the value of unpaid labor from accrual net farm income and divide by the average of your beginning and ending net worth to find the percentage return received on your own capital invested in the operation. Is this more or less than could have been received if the same investment were placed in a savings account or another investment? Remember that this rate reflects only current income earned. It does not include any appreciation or deflation in the value of land owned, or reflect differences in riskiness of assets.

Rate of return to total capital
(total assets)
Net farm income, plus interest expense, minus labor value, divided by average total assets, equals the rate of return to total capital (assets), including both net worth and debt capital.
Comparing the cost of credit to the rate of return on total capital shows the effect of leverage on your business. If you are earning a higher rate of return on total assets than the interest rate you pay for bor¬rowed money, then the use of credit is helping your net worth to grow. Leverage can also work against you. For example, if the rate of return on total assets is only 4 percent, and the interest paid for borrowed capital is 12 percent, you can only afford to have $1 of borrowed capital for every $3 of total capital.

Return to labor and management

Net farm income, plus interest expense, minus the opportunity cost of long-term and other farm assets is the residual return to labor and management. This provides you with an estimate of what your hourly rate of return is for your value-added farm business. If you place a higher opportunity cost on land and/or other farm assets than can realistically be expected, labor and management returns may be low or even negative.

Return to management

The financial return to the operator after opportunity costs for both equity capital and labor resources have been subtracted from net farm income is considered to be a return to management ability. This figure will be positive in some years and negative in other years. Weather, market conditions, and other factors cause it to vary widely. If realistic opportunity costs are used, however, a good farm manager should earn a positive return to management more years than not.

These analysis factors will mean more if you have some standards or guidelines to use for comparison. You can compare labor and management earnings to nonfarm opportunities, or compare the rate of return on capital to other investments. But, are your figures good or poor for a farm business? Compare your numbers to your own results from past years, or compare them to averages of other similar farms.

Further Analysis

Financial Performance Measures describe measures and ratios that can help you evaluate the profitability, liquidity, and solvency of your own business over time. Interpreting Financial Performance Measures helps you understand what they mean for your business.

* Adapted from Ag Decision Maker, Iowa State University Extension “Analyzing an Income Statement”, www.extension.iastate.edu/agdm

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