Many producers have finished “year-end tax planning” to manage income tax liability.
I know producers whose goal seems to be “Don’t pay any income taxes.” I tell these producers: “Paying tax is a good thing.” And I warn that if they are really successful with this no-tax strategy, they should not be surprised to suddenly need a new lender. Businesses need to be profitable to stay in business.
Looking at one individual year on an Internal Revenue Service Form 1040 Schedule F does little to tell you about a farm’s profitability.
Looking at several years will give you a better picture, but you need to make adjustments to Schedule F to understand the current profit situation.
Profit statement
A spreadsheet can be used to make the adjustments needed to go from a Schedule F to a profit statement. Here’s how:
- On Schedule F, make adjustments for livestock purchases and breeding livestock, if any.
- Add back in depreciation and interest expenses, and capital asset sales.
- Adjust for inventory, “account payables, receivables and taxes” and basis in capital assets sold. This takes you from a cash basis to an accrual basis income statement.
Producers can sell multiple years’ worth of crops in one year and make it look like they were profitable, when in reality, they were not.
They also may not buy inputs or prepay on inputs, and that may make them look more profitable than they actually are. Low yields may decrease normal inventory, which might not show up until the following year.
Calculating profits
Profits can be calculated in different ways:
- “Accounting profits” is often referred to as “net income.”
- “Economic profits” would include a charge for the capital used by the business along with a charge for the value of labor provided by the family. The owners’ equity could be invested elsewhere and the family could work off the farm and get paid for their labor.
But businesses can be profitable and still have cash flow problems.
Buying capital assets, such as grain bins, and using cash to pay for them may drain a checkbook and make it look like a producer is not profitable.
However, if the cost had been financed, it would not have been such a drain on cash flow.
Businesses can have good cash flow and be unprofitable by spending down inventory or selling off capital assets.
Benchmark farm
By determining profitability, you can benchmark your business against others by looking at the net farm income from operations, the rate of return on farm assets, the rate of return on farm equity and the operating profit margin ratio.
The University of Minnesota has a great tool to use called Finbin at finbin.umn.edu. It allows you to compare your type of farm to similar operations.
When comparing your operation to others, you can look at four different categories.
1. Operating expense ratio. This tells you how your input costs compare to the revenue produced. The lower this number is, the more you have to split between the other three categories. If this number is over 100%, then you need to really look at the cost structure.
2. Depreciation expense ratio. Use caution and try to use actual depreciation in value as compared to “book value” depreciation. There are trade-offs between using older equipment with higher repairs and buying new equipment with greater depreciation costs.
3. Interest expense ratio. This finds the cost of borrowing capital. Higher interest rates and leverage will increase this ratio. It gives an indication of how sensitive your operation is to changes in interest rates.
4. Net farm income ratio. Net farm income can be used to pay for family living expenses, pay down debt or expand the business. In 2024, 50% of the farms in Finbin reported a negative farm income expense ratio.
As we have all heard: “You can’t manage what you don’t measure.”