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Good accounting Part II

Last month, I summarized how some ranchers are being let down by their on-ranch accounting systems. This month, I'll focus on good accounting and how

Last month, I summarized how some ranchers are being let down by their on-ranch accounting systems. This month, I'll focus on “good accounting” and how ranchers can generate good business signals from their beef cow herd's business records. Hopefully, good business signals will lead to better business management decisions.

The first accounting principle to master is that accounting for business profitability, and accounting for family/business cash flow, are two different systems. Each is designed to answer a different set of management questions.

Most on-ranch accounting systems I've reviewed are executed to meet IRS Cash Income Tax reporting needs; managerial accounting is never considered. Similarly, the commercial accounting systems I've reviewed also are directed primarily toward IRS Cash Income Tax reporting. Very few report any managerial accounting data back to ranchers.

This month's column will deal with the topic in simple and general terms; future columns will focus on the details. Let's begin with an understanding of the basic business analysis concepts.

Three questions:

  • The first question a rancher should ask his accounting system is: “What did my family earn this last year from running this ranch?”

  • The second question is: “How does the current year's family earnings compare to those generated in the last five years?”

  • The third question is: “Are my ranch's family earnings trending up or down over the last five years?”

All three questions must be answered from your ranch's profitability accounting system in a summary number I call Net Ranch Income (NRI). So, how does one calculate NRI?

A “ranch-profitability account” generates a year's business summary where the bottom line summarizes the NRI for that business year. Figure 1 presents a simplified ranch-profitability account.

A “good” accounting system generates a total annual operating-income summary number (basically gross receipts). It also accumulates your annual business operating expense. By subtracting operating expenses from operating income, a good accounting system gives a ranch manager his ranch business's net-cash operating income (NCOI).

NCOI, however, doesn't include all business expenses. Machinery, equipment, buildings and breeding-herd depreciation must be subtracted. After that, you must adjust for the differences in beginning and ending inventories in the business.

The inventories that must be accounted for are feed and grain, market livestock (as opposed to breeding stock), accounts receivable, supplies and prepaid expenses, and accounts payable. The sum of these inventory adjustments can be positive or negative.

The bottom line of this profitability analysis is NRI (before taxes). This bottom line is used to measure the “earned-net returns” from the three resources the ranch family contributes to the ranch business:

  • unpaid family and operator labor

  • management

  • equity (family) capital invested in the ranch business

Ranchers must know their annual earned-net returns to the family's resources each and every year they operate the ranch.

Another important, long-run question answerable with multiple years of ranch-profitability analyses is: “Is my current ranch business a profitable use of my family's resources, or should my family's resources be employed in a different manner?”

When ranchers ask me if they should change their calving date, it's really a business management question best answered by looking at alternative projected NRIs.

Earned-net-cash flow

The second major set of questions a rancher must ask is: “Is my ranch generating a positive or negative cash flow?” In other words, “Is my business's financial structure such that I can meet the annual cash flow needs of my business (and family)?” You answer this question with a bottom-line summary entitled “earned-net-cash flow.”

Figure 2 presents a simplified earned-net-cash flow summary table. Starting with the same NCOI as you did in the profitability analysis, you subtract the debt principal payments. (Interest payments are in the operating expenses.) Family-living draw is also subtracted out, as are capital purchases.

Sales of capital assets are added back in, and income taxes and Social Security payments paid that year are subtracted out. (Remember, taxes paid lag by one year.) The remaining number is the earned-net-cash flow of the ranch business.

Capital assets may be financed by equity capital or borrowed capital, or some combination of the two. Family living may be financed from within the ranch business or from off-farm employment, or some combination of the two. How the ranch's capital assets, such as cows, machinery and equipment, and the family-living draw are financed makes a huge difference in earned-net-cash flow, as is the financial structure of the ranch business.

Earned-net returns vs. cash flow

The earned-net returns summary and the earned-net-cash flow summary both start with the same NCOI summary number. But the similarity ends there.

Earned-net returns adjust the NCOI into an accrual-adjusted income statement. That is, NCOI is adjusted for inventory adjustments and depreciation.

The earned-net-cash flow account, on the other hand, adjusts the NCOI for capital expenditures, debt repayments, family-living draw and taxes paid.

The earned-net return summary and the earned-net-cash flow summary are both needed to properly assess business performance. Because of completely different adjustments, these simply are two different accounting summaries of the same ranch business. Without these two summaries, ranchers are being let down by their on-ranch accounting systems.

One final point. A ranch doesn't have to be profitable every year. It should, however, be profitable more years than not.

On the other hand, a ranch does have to cash flow every year. If it doesn't, you'll be visiting with your banker to borrow more money.

How you finance your ranch business and how you finance your family-living draw are two critical ingredients for managing the cash flow of your ranch business.

Figure 1: Earned-net returns from the ranch
Operating Income $_____________
Minus Operating Expenses $_____________
Equals Net-Cash Operating Income $_____________
Minus Depreciation $_____________
Plus or Minus Inventory Change $_____________
Equals Net Ranch Income $_____________
Earned net returns to unpaid family & operator labor, managment and equity capital
Figure 2: Earned-net-cash flow
Operating income $_____________
Minus Operating expenses $_____________
Equals Net-cash operating income $_____________
Minus Dept principal paid $_____________
Minus Family-living draw $_____________
Minus Capital purchases $_____________
Minus Capital sales $_____________
Plus Income taxes & social security paid this year $_____________
Equals Earned-net-cash flow $_____________
Singling out family-living draw

When I find a ranch family that doesn't separate the family-living draw in its accounting system, I immediately suspect family-living draw is a cash-flow weakness in that business. I'm rarely proven wrong.

Figure 3 illustrates my concern and focus on family-living draw. Our farm business management data shows North Dakota farmers and ranchers' family-living draw per farm is trending upward of $1,500/year. That means, on average, it takes the net-cash-flow from 15 more cows annually just to generate the increased family-living draw. That's 15 cows every single year!

Without annual family/business measurements, family-living draw can creep ahead of the business's ability to generate it. It's why so many farms and ranches today have someone working off the operation to generate a family living.
Harlan Hughes

Click HERE to download Figure 1.

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