By the time you read this, you'll likely be working on your 2006 ranch income taxes and pondering your ranch's 2006 business performance. Given today's economic environment, it's important you glean all the management signals possible from your 2006 business performance. Such a review sets the stage for your business planning for 2007 and beyond.
As ranch businesses begin to feel added economic pressures from rising corn prices, cash accounting can no longer cut the mustard. Cash flow is very important, but so is the awareness that your ranch's resource combination is working economically. Is your current production system a profitable use of your ranch resources? Cash-flow accounting can't and doesn't answer that question.
Beef-cow producers need to go beyond cash accounting to ensure their ranch businesses are economically efficient and headed in the right direction. Astute ranchers use year-end managerial accounting summaries to learn the economic performance of their current resource combinations and current production plans.
If the production plan is working, that's great. If it isn't, figure out the cause and fix it. Running a herd without good managerial accounting documents is like branding a calf with one hand tied behind your back.
My last three columns focused on ranchers' accounting needs and provided producers with tools for a thorough understanding of the financial performance of their ranch businesses. This month, I'll illustrate the managerial accounting documents I recommend for a full grasp and proper analysis of the performance of your 2006 ranch business.
For example data, I'll use the 2005 accounting summary from 403 North Dakota Farm Business Management (NDFBM) farms/ranches, as the 2006 numbers aren't yet available.
Three key documents
Table 1 presents the North Dakota statewide average earned-net income from the North Dakota farms/ranches. On average, these operations generated $334,712 of operating income, spent an average of $269,394 for operating expenses and generated an average of $65,318 in net-cash operating income (NCOI).
After adjusting NCOI for depreciation (-$23,873) and inventory change (+$18,161), the calculated “earned-net” farm/ranch income was $59,606. This means these 403 operations earned an average of $59,606 for unpaid family and operator labor, management and the family's equity capital. These were the earned returns generated by the family's total resources contributed toward the farm/ranch business.
Earned net-cash flow (ENCF) from the ranch business is a different story (Table 2). With no way of knowing for sure, I assume a large part of the average debt principal paid was related to an annual operating loan. Even without principal payment, the farm/ranch business generated a negative $48,153 ENCF.
In summary, the average North Dakota farm/ranch business, in itself, didn't generate a positive cash flow in 2005. Outside capital made these firms cash flow.
Table 3 illustrates all sources of cash funds (both farm/ranch and non-farm/ranch funds) available — including money borrowed. The average total cash available from farm and non-farm sources was $641,211 for the year, and total net-cash outflow was $600,788.
Meanwhile, net cash flow from all sources was a positive $40,423. After income tax and Social Security payments and non-farm/ranch business capital purchases, the ending cash balance was $25,797. So, when non-farm cash flow is added in, the average farm and ranch did cash flow, but only if borrowed capital and non-farm income are considered.
Managerial accounting documents
The next three tables illustrate the detailed accounting items used to generate these managerial accounting documents.
The left-hand side of Table 4 presents the detailed gross income numbers for a farm/ranch. The example “ranch receipts” are somewhat aggregated, since the average of 403 farms/ranches is being used. Generally, an individual rancher can list each major gross receipts category. Please note that cull-cow income is handled in Table 6. Again, the average “gross ranch receipts” for these farms/ranches was $334,712.
Operating expenses are shown on Table 4's right-hand side. (Many of these expense categories correspond to the IRS 1040 Form used in tax preparation.) In this instance, total operating expenses averaged $269,394, leading to a calculated net cash ranch income (NCRI) of $65,318.
This $65,318 NCRI figure isn't yet the bottom line for the ranch. You must adjust NCRI for inventory depreciation and also for capital purchases.
Table 5 presents the average inventory adjustment for the 403 operations. The calculated average inventory adjustment was a positive $18,160. That is, these farms/ranches had more inventory on hand at the end of the year than at the beginning.
The value of this added inventory was produced in 2005 and must be considered as part of the gross production of these farms/ranches; therefore, it was added to NCRI and generated an average $83,478 net operating profit for these farms/ranches.
Total net capital adjustments (NCA) for these operations was -$23,872 (Table 6), the biggest share of which is depreciation. Cash accounting doesn't take depreciation into account.
Adding in this NCA led to the operations' final “net income” of $59,606. This is the average net income these families earned for the three resources they provided.
Many ranchers are being let down by their on-ranch accounting systems — sometimes even being misled. Cash accounting is extremely popular among ranchers, but it can't tell the correct or total business story. Management decisions based strictly on cash accounting can lead to less than optimal — and sometimes disastrous — business strategies.
Given the current economic environment of higher corn prices, every rancher must use the absolute best managerial accounting data possible in making decisions about ranching in 2007 and beyond. Only with a true and correct business picture can ranchers formulate the best business strategies.
Harlan Hughes is a North Dakota State University professor emeritus. He lives in Laramie, WY. Reach him at 701-238-9607 or firstname.lastname@example.org.
More on capital adjustments
The biggest share of capital adjustments in Table 6 (-$19,338) is in the “machinery & equipment” column, and primarily represents machinery and equipment depreciation. Ranchers who try to manage strictly by cash accounting never see this machinery depreciation number.
Cash accounting suggests the major cost of that machinery (depreciation) was never considered in the business-management decisions. Managerial accounting would have prevented some ranches from being dragged down by its “iron.”
Another capital adjustment that ranchers tend to ignore is the breeding-livestock adjustment. For example, when beef-cow herds are downsized due to drought, it tends to generate a negative adjustment. Ranchers utilizing cash accounting never take this negative adjustment into account.
The opposite is true for ranchers who expand their herds. This adjustment tends to be positive, but cash accounting doesn't account for this business growth. By ignoring the added production, cash accounting sends the operator the wrong business management signal.