March 15, 2014
How to Evaluate a Capital
Purchase
Tools and ideas to
help make a financial
decision.
2
The Decision Making Model
Before making a major purchase decision,
ask yourself the following questions:
• Why do you want to make this purchase?
• Can you manage your operation more
efficiently instead of making a capital
purchase?
• Where is your business in its lifecycle?
3
The Decision Making Model
• What is the state of your industry?
– Depressed, stable, or growing?
• How strong is your management team?
– Management is an important element of your
business.
• How does your need for financing mesh
with your business plan?
– If you don't have a business plan, make
writing one your first priority!
4
What’s a SWOT Analysis?
Tool to help you evaluate the:
Strengths, Weaknesses,
Opportunities, and Threats (SWOT)
of your business
Every member of your team should be
involved in the process!
5
S.W.O.T.
Internal
 Strengths
 Weaknesses
External
 Opportunities
 Threats
Strengths
Weaknesses
Opportunities
Threats
S.W.O.T.
For each weakness or threat, there
should be an off-setting strength or
opportunity to compensate.
If this is not the case, then these areas
need to be addressed.
Strengths
• Considered mostly Internal
• What do you and your family or
management team bring to your business?
8
Strengths
Examples
Internal element
• Low-cost producer
– Financial Plan
• Competent and reliable employees
– Resource inventory
• Marketing niche
– Marketing plan
• Expertise in production
– Production plan & resource inventory
(skills)
Weaknesses
• Generally considered Internal
• These are the factors you will need to
address to run a successful business
10
Weaknesses
Examples
Internal element
• Highly leveraged
– Financial plan
• Lack of experience in the industry
– Mentor, education
• Not utilizing futures market
– Marketing plan
• Inadequate facilities or machinery
– Resource inventory
• Are there siblings fighting over family
land?
Opportunities
• Considered mostly External
• What opportunities are available to your
business?
• Advantageous choices and directions for
the business.
12
Opportunities
Examples
External element
• Are there new technologies that
would lower costs?
• Will diversification of enterprises
increase profit?
• Can my operation command a
competitive edge?
Threats
• Considered mostly External
• Threats from outside your business that
will directly affect you
• Have very little control over them
14
Threats
Examples
External element
• Ethanol explosion to a cattle
feeder
• Drought causing water shortage
• Unforeseen competition (local or
foreign)
• Regulatory Changes
Financial and Management
Benchmarks
• Know your financial benchmarks
• Equity
• Liquidity
• Efficiency Ratio
• Know your management benchmarks
•
•
•
•
Cost of production
Credit Score
Risk Management
Business Plan
Measurement Tools:
•
•
•
•
Easy to Use
Comprehensive and meaningful
Accurate
Appropriately calculated
17
Equity Position
Total Farm Equity ÷ Total Farm Assets
(Total Farm Equity is the Total of Farm Assets minus the Total of Farm Liabilities)
Example:
$1,000,000 (total assets) - $600,000 (total liabilities) = $400,000 (equity)
$400,000 (equity) ÷ $1,000,000 (total assets) = 40% Percent Equity
You own 40% of your assets
18
Liquidity
Working Capital ÷ Total Expenses
(Working Capital is Current Assets minus Current Liabilities)
Example:
$300,000 (current assets) - $200,000 (current liabilities) = $100,000
(working capital)
$100,000 (working capital) ÷ $400,000 (total expenses) = 25% Liquidity
19
Efficiency Ratio
Total Expenses (minus interest minus depreciation) ÷ Total Revenue
Example
$400,000 (Total Expenses) - $50,000 (interest & depreciation) = $350,000 (operating
expenses) ÷ $500,000 (total revenue) = 70%
20
Key Ratios & Practices
Guidelines Only - - These can vary by lender and/or commodity
Metric
Green
Yellow
Red
Equity Position
>65%
35-65%
<35%
Liquidity
>50%
20-50%
<20%
Efficiency Ratio
<70%
70-80%
>80%
Credit Score
+700
650-700
<650
Business Plan
Written and Review Partial Plan
Annually
Verbalized
None
Know Cost of Production
By Enterprise
Farm Ranch
Overall
None
Risk Management
All Components
Some
None
21
Why “Positive Cash Flow” is
So Important…
1. Provides funding for business expansion
Cash from operations should support at least
25% to 40% of costs related to expansion
2. Enables discretionary equipment
purchases or improvements to property
and facilities
3. Creates flexibility for management
decisions
4. Limits reliance on creditors
Case Study Analysis Exercise
Help Tom and Jane become more confident
about whether or not to make this land
purchase by doing the following:
• Perform a SWOT analysis
• Complete assessment of the key financial ratios
• Complete assessment of management
benchmarks
• Decide if Tom and Jane should or should not
purchase the property
23
Meet the Smith Family
• The Smith family has operated a hay
operation for over 15 years.
• The family withdraws about $60,000 each
year for family living.
• The operation is located in a rural area, but
urban city is close by.
• Tom and Jane have two children (ages 20
and 17), both whom help out on the farm and
have shown interest in coming back after
college.
24
Meet the Smith Family (continued)
• Jane works off the farm for an accountant with take
home pay of $20,000 plus health, dental and other
benefits that extend to the whole family.
• Tom completes a cash flow budget each year and Jane
uses QuickBooks to input their expenses and income
and reconciles each quarter.
• Their neighbor Sally wants to sell 50 acres (planted in
corn) for a sale price of $300,000.
• This additional land should be able to generate a net
income after all costs of $50,000
• Bank financing is available for $270,000
25
Financial & Benchmarking
Tom & Jane Smith
Before Purchase
Key information from the case study is as follows:
Balance Sheet
Current
Income Statement
Current Assets
$300,000
Total Revenue
Non-Current Assets
$700,000
Total Assets
$1,000,000
Current
Other Information
$500,000
Jane's Credit Score
790
Interest Expense
$25,000
Tom's Credit Score
690
Depreciation
$25,000
Operating Expenses
$350,000
Crop Insurance?
Yes
Current Liabilities
$200,000
Total Expenses
$400,000
Hedges & Options?
No
Non-Current Liabilities
$400,000
Net Farm Income
$100,000
Knows Cost of Production?
Yes
Total Liabilities
$600,000
Non-Farm Income
$20,000
Net Worth
$400,000
Family Living Expense
($60,000)
Income Taxes
($30,000)
Total Net Income
Business Plan?
Debt Service
Thinking about it
$50,000
$30,000
26
Financial & Benchmarking
Tom & Jane Smith
After the Purchase
If Tom and Jane purchase the property, key financials will change as follows:
Balance Sheet
Current Assets
Post Purchase
$270,000
Income Statement
Total Revenue
Post Purchase
Other Information
$600,000
Jane's Credit Score
790
Tom's Credit Score
690
Non-Current Assets
$1,000,000
Interest Expense
$50,000
Total Assets
$1,270,000
Depreciation
$25,000
Operating Expenses
$375,000
Crop Insurance?
Yes
No
Current Liabilities
$225,000
Total Expenses
$450,000
Hedges & Options?
Non-Current Liabilities
$645,000
Net Farm Income
$150,000
Knows Cost of Production? Not by Enterprise
Total Liabilities
$870,000
Non-Farm Income
$20,000
Net Worth
$400,000
Family Living Expense
($60,000)
Income Taxes
($30,000)
Total Net Income
Business Plan?
Debt Service
Thinking about it
$100,000
$80,000
27
Your Task:
•
•
•
•
•
Review the Equity Position Ratio
Review the Liquidity Ratio
Review the Efficiency Ratio
Perform a SWOT
Decide if Tom & Jane should purchase the
property.
28
Financial Ratios
• Equity Position
– Before Purchase
– After Purchase
• Liquidity
– Before Purchase
– After Purchase
• Efficiency
– Before Purchase
– After Purchase
40%
31%
25%
10%
70%
63%
29
Management Benchmarks
• Knows Cost of Production
__________
• Credit Score
__________
• Risk Management
__________
• Business Plan
__________
30
S.W.O.T
Strengths (internal)
Weaknesses (internal)
31
S.W.O.T
Opportunities (external)
Threats (external)
32
Financial & Management
Benchmark
Benchmark Measure
Green
Yellow
Red
Tom & Jane
Before
Purchase
Tom & Jane
After
Purchase
Equity Position
>65%
35-65%
<35%
40%
31%
Liquidity
>50%
20-50%
<20%
25%
10%
Efficiency Ratio
<70%
70-80%
>80%
70%
63%
Knows cost of
Production
By
Enterprise
Overall
None
Credit Score
>700
650-700
<650
Risk Management
All
Components
Some
None
Business Plan
Written
Verbalized
None
33