Farm Management
Chapter 6
The Income Statement
and Its Analysis
Chapter Outline
• Identifying Revenue and Expenses
• Income Statement Format
• Accrual Adjustments to a Cash-Basis
Income Statement
• Analysis of Net Farm Income
• Change in Owner Equity
• Summary
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Chapter Objectives
1. To discuss the purpose and use of an
income statement
2. To illustrate the structure and format of
an income statement
3. To define the sources and types of
revenue and expenses included
4. To show how net farm income is
computed and what it means
5. To analyze farm profitability
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What is an Income Statement?
An income statement is a summary of
revenues and expenses as recorded
over a period of time.
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Figure 6-1
Relation between balance sheet
and income statement
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Identifying Revenue and Expenses
• Revenue: revenue should be recognized
as soon as a commodity is ready for sale,
whether or not it is actually sold
• Gain or loss on sale of capital assets:
difference between sale price and book
value
• Expenses: all expenses incurred in
producing the revenue for an accounting
period should be included
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Income Statement Format
Total revenue
Less total expenses
Equals net farm income from operations
Plus or minus gain/loss on sale of
capital assets
Equals net farm income
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Table 6-1
Income Statement Format
Revenue:
Cash crop sales
Cash livestock sales
Inventory changes:
Crops
Market livestock
Livestock product sales
Government program payments
Change in value of raised breeding stock
Gain/loss from sale of culled breeding stock
Change in accounts receivable
Other farm income
Total revenue
Expenses:
Purchased feed and grain
Purchased market livestock
Other cash operating expenses:
Crop expenses
Livestock expenses
Fuel, oil
Labor
Repairs, maintenance
Property taxes
Insurance
Other:
Adjustments
Accounts payable
Prepaid expenses
Depreciation
Total operating expenses
Cash interest paid
Change in interest payable
Total interest expense
Total expenses
Net farm income from operations
Gain/loss on sale of capital assets:
Machinery
Land
Other
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Net farm income
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Accrual Adjustments to a Cash-Basis
Income Statement
• The FFSC recommends that anyone using
cash accounting convert the resulting net
farm income to an accrual-adjusted net
farm income at the end of each year
• Two adjustments to cash receipts: change
in inventory values and accounts receivable
• Several adjustments to expenses, including
accounts payable and accrued expenses
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Figure 6-2
Adjustments to get accrual-adjusted net farm
income from a cash-basis income statement
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Table 6-2
Income Statement for I.M. Farmer for Year
Ending December 31, 20003
Revenue:
Cash crop sales
Cash livestock sales
Inventory changes:
Crops
Market livestock
Livestock product sales
Government program payments
Change in value of raised breeding stock
Gain/loss from sale of culled breeding stock
Change in accounts receivable
Other farm income
Total revenue
$133,100
68,400
(8,000)
1,700
0
3,400
0
600
1,200
0
$200,400
Expenses:
Purchased feed and grain
Purchased market livestock
Other cash operating expenses:
Crop expenses
Livestock expenses
Fuel, oil
Labor
Repairs, maintenance
Property taxes
Insurance
Other: Utiliites
Adjustments
Accounts payable
Prepaid expenses
Accrued expesnse
Depreciation
Total operating expenses
Cash interest paid
Change in interest payable
Total interest expense
Total expenses
Net farm income from operations
Gain/loss on sale of capital assets
Machinery
Land
Other
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Net farm income
12,000
28,000
44,500
6,500
3,200
8,400
3,600
2,800
2,000
2,400
1,000
1,500
0
8,200
124,100
30,000
(500)
29,500
153,600
46,800
1,100
0
0
1,100
$47,900
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Net Farm Income
Net farm income is the amount by
which revenue exceeds expenses,
plus any gain or loss on the sale of
capital items. It represents the return
to the operator for unpaid labor,
management, and equity capital.
Net farm income from operations
excludes gain or loss on sale of
capital items.
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Analysis of Net Farm Income
•
•
•
•
•
•
Rate of return on assets
Rate of return on equity
Operating profit margin ratio
Return to labor and management
Return to labor
Return to management
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Adjusted Net Farm Income
Net farm income from operations
Plus interest expense
Equals adjusted net farm income
from operations
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$46,800
29,500
$76,300
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Opportunity Costs of
Labor and Management
The opportunity cost of unpaid labor is the
estimated amount that any unpaid farm
labor could have earned elsewhere.
The opportunity cost of management is
the estimated amount that the operator
could have earned for that management
time had it been used in paid work.
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Return to Assets
Adjusted net farm income
from operations
$76,300
Less opportunity cost of
unpaid labor
-20,000
Less opportunity cost of
management
-5,000
Equals return to assets
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$51,300
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Rate of Return on Assets
(ROA)
Rate of return
on assets (%) =
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return to assets ($)
 100%
average farm asset
value
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ROA for I.M. Farmer
ROA
=
$ 51,300
 100%
$725,750
= 7.07%
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Return on Equity
Net farm income from
operations
$46,800
Less opportunity cost of
unpaid labor
-20,000
Less opportunity cost of
management
-5,000
Equals return on equity
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$21,800
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Rate of Return on Equity (ROE)
Rate of return
on equity (%) =
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return on equity ($)
 100%
average equity ($)
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ROE for I.M. Farmer
ROA
=
$ 21,800
 100%
$358,565
= 6.08%
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Comparing ROA and ROE
If ROA > i then ROE > ROA
If ROA < i then ROE < ROA
Where i is the interest rate on borrowed
capital. Thus, if ROA > ROE borrowed
capital is earning, on average, less than
the interest rate. If ROA < ROE,
borrowed capital is earning, on average,
more than the interest rate.
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Operating Profit
Net farm income from
operations
$46,800
Plus interest expense
29,500
Less opportunity cost of
unpaid labor
-20,000
Less opportunity cost of
management
-5,000
Equals operating profit
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$51,300
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Operating Profit Margin Ratio
Operating profit operating profit
 100%
=
margin ratio
total revenue
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Operating Profit Margin Ratio for
I.M. Farmer
Operating profit
=
margin ratio
=
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$ 51,300
 100%
$200,400
25.6%
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Opportunity Cost of Capital
To find the opportunity cost of capital,
multiply the opportunity interest rate
(e.g. what the capital could earn elsewhere)
times the average total asset value.
For I.M. Farmer: $725,750×8% = $58,060
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Return to Labor and Management
Adjusted net farm income
from operations
$76,300
Less opportunity cost of
all capital
-58,060
Equals return to labor
and management
18,240
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Return to Labor
Return to labor
and management
Less opportunity cost of
management
Equals return to labor
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$18,240
-5,000
$13,240
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Return to Management
Return to labor
and management
$18,240
Less opportunity cost of
labor
-20,000
Equals return to management
-$1,760
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Change in Owner Equity
• Retained farm earnings: the part of farm
earnings, after taxes and personal
withdrawals, that is retained for use in the
farm business
• A positive retained farm earnings
increases owner equity
• If taxes and living expenses are greater
than total earnings, owner equity will fall
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Figure 6-3
Relation between net farm income
and change in equity
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Summary
An income statement organizes and
summarizes revenue and expenses for an
accounting period. Net farm income, or
profit, is a dollar amount, whereas
profitability relates profits to the size of
the business.
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