Analyzing and Managing Your Cash Flow
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Table of Contents
While all business owners hope their businesses will never have financial problems, in reality, most businesses experience financial pressure at some point. This factsheet is designed to help you diagnose a cash-flow shortage and take some steps toward correcting it.
The sooner you can diagnose the problem, the better. Early diagnosis gives you more time to make decisions and more options to correct cash-flow issues concerning your farm business.
Most farm businesses become aware of potential financial problems when cash flow becomes tight and obligations become increasingly difficult to meet in the short and medium term. This may indicate a temporary short-term problem (such as a poor growing season) that will correct itself in time, or it may indicate a more serious long-term problem.
Your first step is to determine if the problem is short or long term. The distinction between the two is important. Long-term problems require significant business adjustments to correct and, if left uncorrected, have the potential to result in business failure.
There is a simple three-step approach to diagnosing a cash-flow problem.
Step 1 Determine if the current cash-flow shortage is short or long term.
Step 2 Calculate your business equity.
Step 3 Identify the primary cause of the cash-flow problem.
Once these steps are completed, you can determine what your options are.
Step 1. Determine if the current cash-flow shortage is short or long term.
Complete a debt-servicing capacity worksheet to indicate if you have enough cash to cover all your obligations in the coming year. Include both an optimistic and a pessimistic forecast. While you hope for the optimistic outcome, you should be prepared for the pessimistic one. Appendix 1 of this factsheet is a blank Debt-Servicing Capacity worksheet.
The debt-servicing capacity worksheet summarizes several key pieces of financial information. In order to get the most accurate results, you will need to gather information from your accounting software or bookkeeping records and your tax slips to come up with the following:
Include the value of saleable inventories on hand in the calculation of farm cash revenue, as well as the value of saleable inventory that you expect to have in storage in your cash-revenue projections.
Debt-servicing capacity, below, shows an example of the calculation. Appendix 1, on pages 6-7, includes a worksheet for your use.
Debt-servicing capacity Projected year
+ farm cash revenue $380,000
farm cash expenses $328,000
= Net Cash from Operation $52,000
+ interest payments $18,000
+ owners contributions $8,000
owners withdrawals (including taxes) $42,000
= Cash Available for Principal and Interest $36,000
principal and interest payments $31,000
= Cash Available After P & I Payments $5,000
depreciation or reserve for asset acquisition $20,000
= Debt-Servicing Capacity ($15,000)
This example shows that there is cash available to cover the interest and principle payments but not enough to cover depreciation. Depreciation or a reserve for asset acquisition is used to replace assets as they wear out. In this example, a shortage of $15,000 exists.
Back of the envelope analysis - The information summarized in the debt-servicing capacity worksheet on page 7 can also be used to project break-even prices for crops or livestock. The total of principal and interest payments, owner's withdrawals and operating debt can be divided by the projected production to determine the break-even price needed.
Step 2. Calculate your business equity.
Knowing your equity position enables you to judge the business's ability to survive the cash shortage. A cash-flow shortage that persists ultimately reduces the owner's equity. High-equity businesses have the ability to withstand a longer and more serious cash-flow shortage because they can re-borrow against their equity. Businesses with low equity are unable to tolerate cash-flow shortages and therefore are at much greater risk.
Knowing your equity position also allows you to pre-determine the minimum level of equity that you wish to maintain in the business. This is important, because the equity in the farm business represents the retirement savings for many farmers. It is important to protect that investment. You may, for example, decide that you will not let your equity position fall below a certain amount, say $500,000. If you know your current equity position and the projected cash shortfall, you can calculate if you are at risk of falling below that amount.
Equity can be determined by subtracting your total liabilities from your total assets. To determine the equity as a percentage, divide your equity by your total assets and multiply by 100.
The equity of the business is always stated on the balance sheet, but it can vary widely, depending on how the assets are valued. Statements prepared for accounting purposes use cost less depreciation to value assets, which is the purchase cost of the asset minus the depreciation taken for tax purposes. Statements prepared for lenders use fair market value, which is the sale value of the asset. For the purpose of evaluating your business equity, use conservative fair market values.
Equity example: (equity x 100) ÷ total assets = per cent
Figure 1. Equity example.
Step 3. Identify the primary cause of the cash-flow problem.
The most important and most difficult step in the process is identifying the cause of the cash-flow shortage. This can be done by examining the efficiency, scale and debt structure of the business.
Some producers might immediately feel defensive when the word efficiency is used. Often they have worked very hard at becoming more efficient, only to see returns diminish. Sometimes this is because of depressed commodity prices. However, it is important to determine if the cash-flow problem will continue even after prices increase. If the efficiency of the business is even slightly below average, even good prices may not generate the profits needed to maintain a positive cash flow.
Scale is measured by the physical and economic output of the business. Because there is no one measurement of efficiency, you must look at a combination of physical and economic measurements such as yield per acre or variable costs per unit of output.
Scale of the Business
Scale refers to the size of the business. Farms can be too large or too small in relation to the amount of labour used in the business. In large, complex operations, managerial control may be spread too thin.
Tables 1 and 2 compare the financial figures of two sample farms. Farm 1 has a higher cost of producing a dollar of product and a higher percentage of variable costs. This suggests that efficiency may be a problem, and the reasons for these differences should be investigated further.
For smaller farms, there may be too much labour. Or for farms where only the owner is employed in the business, the scale of the farm may still be too small to fully support their labour, creating a cash-flow shortage.
Where this occurs, the options available are to further increase the size of the business, decrease costs or attempt to find a higher-value product that generates larger margins.
One method of accessing scale is to examine the efficiency of labour usage in the business and compare it to similar operations. Table 2 shows that Farm 1 is not being as efficient as it could be, as the cost to produce $1 worth of product is greater than the benchmark. In this case, there may be too much labour on Farm 1, or the business is too small.
Debt structure is the term used to describe the factors that determine the size of your principal and interest payments. These factors are interest rate, size of the debt, the length of the term and the proportion of short-term debt to long-term debt. Each of these can affect the size of the debt payment required, which, of course, impacts the cash flow of the business.
A farm business can limit its efficiency, scale and earning capacity by deciding to use little or no debt capital. For the most part, however, debt structure problems arise when the debt load is excessive, too expensive or must be paid off over too short a term.
Some debt structure problems are relatively easy to resolve - for example, lengthening loan terms to improve cash flow. Most, however, involve adjusting the asset or liability structure of the business. Farmers might sell assets and reduce liabilities. Or they may simply attempt to eliminate assets that have debt-service requirements in excess of their cash-generating potential.
Farm 2 appears to have too much short-term debt as the percentage of current liabilities compared to total liabilities is significantly higher than the benchmark and Farm 1. The percentage of current liabilities to total liabilities at 41.7% suggests that the term on the debt may be too short. (The amount of principal and interest that is due in the current year is considered a current liability.)
Table 1. Farm case study - comparison
Table 2. Farm case study - with benchmarks
* Cautionary Note About Ratios - Whenever ratio or financial indicators are used, it is important to remember that a ratio outside a normal range is just a flag to prompt you to investigate further. In many cases, there may be an explanation for the abnormal figure. Ratios cannot be used on their own to diagnose the problem; they only help you narrow down your search.
These steps and tools will help you determine whether or not you are facing a cash-flow problem. This factsheet will outline possible solutions that can be implemented that will help solve the cash-flow problem.
Figure 2, Financial troubleshooting diagnostic tree, is a tool that helps examine the efficiency, scale and debt structure of a farm business. Use the decision tree to determine which areas of the business need fixing.
While this tool oversimplifies the process, it helps show how efficiency, scale and debt structure can be addressed and what action might be appropriate to remedy each problem. The choices facing a farm business can vary quite widely. A farm business with acceptable efficiency but unacceptable scale and debt load faces choices quite different from a farm with poor efficiency, acceptable scale and unacceptable debt load.
Further, there is always a question of which problem should be fixed first.
If you do not want to use the decision tree, complete this checklist, then refer to Table 3.
Table 3, Financial strategies for change, presents several management courses of action for each branch on the diagnostic tree. This is not an exhaustive list, but simply illustrates ways in which cash-flow problems might be resolved, given a farm's efficiency, scale and debt structure.
Figure 2. Financial troubleshooting diagnostic tree.
Table 3. Financial strategies for change
Some of the suggestions listed above require that you do further analysis. See Appendixes 1-5 of this factsheet:
Appendix 1 - Debt-Servicing Capacity Worksheet
Appendix 2 - Government Programs
Appendix 3 - Preparing Cash-Flow Projections
Appendix 4 - Financial Analysis Resources
Appendix 5 - Meeting With a Lender
Examining the three areas of efficiency, scale and debt structure is important in managing your cash flow. The next few pages outline possible action steps that can be taken once a cause is identified. Not all of the solutions will be applicable to individual situations. Also, it is clear that some of the suggested solutions may be difficult to implement because they require significant changes to the business or roles family members play in the business or both. Nevertheless, when a cash-flow shortage is a long-term problem, decisive action must be taken.
When dealing with cash-flow shortages, please consider the following:
Using the worksheet, first calculate your debt-servicing requirements, then calculate your debt-servicing capacity.
Your current debt-servicing requirement is the total principal and interest payments you must pay in the coming year.
The debt-servicing capacity is the ability to pay annual interest and principal after other cash and family living expenses have been paid.
Debt-servicing capacity is usually calculated on a cash basis. The exception is the inclusion of crops in storage. Some banks allow these to be included if they are readily available for sale.
Debt is paid from cash flowing into the business. This would include not only farm sources of cash income but also off-farm and personal income. Likewise on the expense side, farm expenses are not the only requirements for cash. Personal living expenses, income tax and reserve for purchasing assets are also considered.
Note that liabilities are usually separated into two types, current and term liabilities.
Current liabilities: items that must be paid within 12 months.
Term liabilities: longer-term obligations that require only a portion of the debt to be paid within 12 months. This would include accounts payable, property tax arrears and bank operating loans.
Debt-Servicing Capacity Worksheet
1. Debt - Serving Requirements (When using as a projection, include new loans)
For the period:_____________
2. Debt-servicing capacity
Appendix 2. Government Programs
Government assistance programs can help you manage cash-flow shortages in some cases. For example, business risk programs such as AgriStability can provide income support.
Under the Canadian Agricultural Partnership (the Partnership), there may be opportunities to access cost-shared funding to undertake financial assessments and/or business planning. The Ontario Soil and Crop Improvement Association is delivering the Partnership producer program for OMAFRA. For full details, visit their website or call them at 1-800-265-9751.
For a complete listing of OMAFRA programs, see the OMAFRA Factsheet Programs and Services for Ontario Farmers.
Appendix 3. Preparing Cash-Flow Projections
The cash flow projection is an extremely useful management document. It predicts cash shortages and shows which expenses and revenues have the greatest impact on your business. It also highlights when your credit demands will be the greatest. The cash-flow projection does not monitor the changes in receivables, payables and inventory. These can be reviewed by examining your income statement and balance sheet.
Preparation of a Cash-Flow Projection
A cash-flow projection is an estimate of when and where cash inflow and cash outflow will occur in the coming year. It includes cash inflows from:
Only cash items are included in the inflows and outflows. Make your projections conservatively.
There are two ways of preparing a cash-flow projection:
A cash flow projection may be set up for various time periods, usually monthly, quarterly or annually. Set up an annual projection, as a starting point, then modify it to a quarterly or monthly version, if necessary.
Monitoring a Cash-Flow Projection
Monitor your cash-flow projections monthly, quarterly or annually to correspond to the cash-flow projection format. Monitoring will reveal differences between the actual and the projected, which allows you to consider what adjustments to the business must be made.
Appendix 4. Financial Analysis Resources
The following is a list of resources that can help you in preparing a cash-flow projection and other useful analysis information. All are available on OMAFRA's website.
Farm Business Analyzer - an Excel spreadsheet that analyzes your business using the figures from your farm income tax statement. It also allows you to analyze the effects of changing revenue, variable expenses and family living costs on your net income.
Farm Financial Analysis and Planning Workbook, Publication 37 - an Excel spreadsheet that has a step-by-step system for producing a complete set of financial statements, including a cash flow, debt-servicing capacity worksheet and current and projected income statements.
Ontario Enterprise Budgets - Enterprise budgets are developed to help producers evaluate the economics of production decisions. A range of cost of production budgets are on the OMAFRA website.
The budgets are available in two formats: budgeting tools, which are Excel spreadsheets, and Field Crop Budgets (publication 60), which can be printed directly from the website and completed by hand.
Appendix 5. Meeting with a Lender
If an analysis reveals that changes are necessary in the business, you will usually have to meet with your lender. Be prepared to answer the following questions:
Production and Marketing
This factsheet was written by Rob Gamble, BSc.(Agr), MTax, and updated by Erich Weber, CPA, BComm, Business Finance Specialist, OMAFRA, Guelph.
Sections of this factsheet were modified, with permission, from an Iowa State University Extension publication called Financial Troubleshooting, authored by Robert W. Jolly and Alan Vontalge.
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