As advisors, we see many business and farm financial statements through out the year.  Most of the successful farm businesses have several key financial ratios in common.  Even though each farm business is different, it is surprising how these ratios tend to be in the same range for each business.

These key ratios that we look at are as follows:

• Current Ratio – This is the ratio of current assets comprised of cash, inventories and receivables divided by current liabilities comprised of short-term notes payable, accounts payable, accrued liabilities and current portion of long-term debt.  This ratio determines how much of your assets will be available to pay off the debts owed over the next year.  It is important to include any long-term debt that will be paid off in the next year.  This ratio should exceed 2:1 and for most successful farm businesses, it is usually over 3:1.

• Net Worth to Debt – This is the ratio of your farm net worth divided by the total debt of the farm.  The higher the ratio the less your farm is leveraged.  Most successful farms will have a ratio that exceeds 2:1 and in most cases will approach 5:1.  A starting farmer’s ratio will usually be much lower than a long-term many generation farmer.  This is one of the ratios that bankers will always put the most importance on.

• EBIDTA – This is your farm earnings before interest, depreciation, taxes and amortization.  The reason this ratio is important is that it places each farm operation on the same level, i.e., you are able to compare a farm bought for cash to a farm bought with debt.  This will let you know for each farm or farm unit what income is being generated by the farm.  This income should always have an expense component for the farmer’s salary to make it comparable to other businesses.  The ratio of EBIDTA to net farm sales will vary greatly depending on the type of farm crop grown, but in general, we should see a ratio that exceeds 20% or more.

• Machinery costs to sales – This ratio seems to be one of the best ratios in determining how profitable a farm is.  The lower that a farm operation can keep this number, then this farm will usually end up in the upper farms in profitability.  Some farmers will lease new equipment each year while others will keep the same farm iron forever, the key is to keep this ratio as low as possible and still get the crop grown and harvested.

I have given you four of the key ratios that I see.  Have you computed yours and are there others that you use on an annual basis.  Let me know!

As advisors, we are actively involved in succession planning for farmers and other businesses.  This is usually a long process and will change over time and as the generations involved grow and mature, their goals will usually change.

There are three main goals related to this planning:

1. Protect – The primary goal of any succession plan is that both generations involved are still protected in the following areas:

                Financial – Are the owners transferring the business still protected from a financial standpoint.  Did they create enough retirement and other assets outside of the farm to protect their retirement income

                Operational – Does the succession plan provide protection from operational issues such as the new generation being ready to take over the farm operation.  Nothing will ruin a farm family quicker than the next generation taking over sooner than ready.

                Entity – Does the succession plan provide for legal and entity protection.  Are they taking advantage of limited liability companies, corporations and trusts where appropriate.

   2.  Provide – Once protection is taken care of, the next step is to provide for both generations.  Is there enough cash flow to provide a normal living standard for both the current generation and the new generation.  If not, how will the farm family address this.  Will they have a spouse work off the farm or one of the heirs.  Will they do custom farming, etc.

  3.  Prosper – After the farm family is protected and provided for, then comes the time to prosper.  Does the farm family have enough management time and experience to expand the farm operation with more acres.  Or do they have excess machine time and people to do custom farming.  Each farm family has different goals when it comes to the prosper stage, but they must always remember to protect and provide first.

What stage is your farm operation in?

For an online video presentation of my “chalk talk” on this subject on the AgDay special “The Legacy Project” go to this link.  Here you will see a farm family discussing their succession plan with Kevin Spafford, host of The Legacy Project” and myself giving him advice.  Later in the show, Kevin and I have a chalk talk on the three P.

I hope you enjoy watching it and let me know of any future discussion topics that you would like to see addressed.

I have enjoyed doing my blog for about a year now and have now started to see some farmers using a blog to communicate with their landlords, neighbors, bankers and others that might be interested.

Reading the latest issue of Successful Farming, I noted an article on the Martin Family Farms in Logan County, Illinois.   The title of the article was “Communication keys their success”.  It was a very good article on how communication between parents and children, employer and employee, and tenant and landlord are extremely important to a successful farm operation (or any business).

Doug Martin decided to create a blog to keep his landlords apprised of what is happening on the farm.  Many of his landlords are located in very distant states such as California.  By using the blog, the Martin’s keep their landlords informed and share what is happening in a real-time efficient manner.  “Anything we can do to communicate to our landlords that they are a part of us, helps them feel a part of the operation.”  I think like most things in life, landlords would rather be part of a good farm community than simply leasing their land each year to the highest bidder.

I would strongly suggest trying to do a similar blog.  I think it would well be worth the effort even if you are not computer savvy.

Here is the Martin Family Farm blog.

Having just recently returned from my taping for the Legacy Project on farm succession planning, I will be trying to do several posts over the next few weeks on this very important subject.

Elizabeth Williams from the DTN/Progressive Farmer had a very good post on the five steps needed for the farm transition.  The article dealt with a young farmer who lost his mother due to brain cancer.  The estate did not owe any current tax since the assets passed free of estate tax to the husband, but if he had passed away that same year, they would have had a major estate tax problem.

The five steps mentioned were:

1. Get Experienced Legal Help – Find a good agricultural estate tax attorney (or a good farm cpa) to help design an estate plan to meet the unique needs of the farm estate plan.
2. Recognize that your Paperwork will Increase – If your estate goal is to reduce estate taxes, transfer property to the next generation with the least income/capital gain tax and divide your assets equitable among your children, that usually means multiple farm entities.  This requires separate bank accounts, year-end meetings and compliance, etc.  However, to do it right, more paperwork will result.
3. Allow the Next Generation to Control or Own Something that is “Theirs” – It is important for the children to have some skin in the game to promote the pride of ownership.
4. Listen and Talk to Each Other – No one can read your mind.  Not being transparent can cause a multitude of problems.  “A lot of animosity can build up when off-farm family members don’t know what the deal is. What is the on-farm sibling getting?”
5. Respect the Division of Labor – The most successful family farm operations have distinct, complementary divisions of labor.  As I said on my TV taping, find what each member does best and let them do it.  The farm will be better off and the family member will feel best about themselves.  Part of that comes from clearly defining the expectations that go along with ownership and management of the farm.

The cost of not planning can be very high!  Even a 500 acre farm can generate a large amount of estate tax starting in 2011 if no changes are made to the estate tax laws.

For a primer on “Transferring the Farm”, go to the University of Minnesota’s Center for Farm Financial Management.

To maximize your profit for your farm, it is very important to determine what your annual fixed costs are and determine if you are maximizing your amortization of these costs on your farm.  Fixed costs are those costs that do not materially change with production increases and decreases. 

Some examples of fixed costs are:

• Depreciation on your equipment
• Insurance costs on equipment
• Your annual salary cost for providing services to the farm operation
• Office related costs
• Other annuals salaries for workers who are not at full capacity

These costs are mostly fixed and if you can increase your production to full capacity, these costs per unit of production will decrease substantially.  The goal is to maximize your production to equal the full amortization of these fixed costs.

Lets say you have a farm with 1,000 acres of production and your total annual fixed costs are $100,000.  This means your average fixed cost per acre is $100.  If you have enough equipment and capacity to farm 2,000 acres and all of your variable costs will remain the same, you will reduce your fixed cost amortization from $100 to $50.  This will result in additional profits to the farm operation of $50,000.

Try calculating these costs for your farm operation and see how it would effect your bottom line.

However, you also need to be careful that as you approach full capacity, you may have to make major investments to go slightly over full capacity.  This can then put your back with higher fixed cost amortization.

As a CPA, I have been involved in many family meetings.  Sometimes, I act as an advisor to the participants.  At other times, I may actually be part of the family that is having the meeting.

I remember having a client several years ago that had several children that were actively involved in the business during their lifetime.  We hada family meeting with several advisors and it became apparent very quickly that strains of the family dynamic and how it affected their relationships.  Very quickly, the perceived problems of childhood, parenthood and other factors came out and you almost had a civil war on your hands.  We were able to get it back on track, but it was touch and go for a while.

Dr. Donald Jonovic writes a monthly column in Successful Farming that I think is always worth reading.  A recent column from the print version of the magazine dealt with  Family Rules of Conduct for these meetings.  Dr. Jonovic listed several rules for effective meetings.  Some of the ones that I feel are especially relevant are:

• Always treat each other the way you would treat important friends or colleagues.  – Too many times I find that family will treat each other worse than any other friend or acquaintance.  We should really treat our family better than our friends.  If we do, many of our family problems would be cured.
• Keep your business and personal disagreements confidential and within the family. – Disagreements should be handled in-house.  Don’t put them in the “outhouse” so to speak. 
• Keep meetings fun – Farming is fun and having meetings about farming and family should be fun.  Have some type of family interactive game or other ice breaker to keep things loose.
• Do not equate difference of opinion with disloyalty – Remember that having people always agree with you means they go over the cliff with you when things go wrong.  Encourage people to give you a different viewpoint.  This is always the best way to learn.
• Leave your cell phones at the door – This may be tougher for our Gen X and Gen Y family members, but it is only for an hour.  They can survive and will learn to enjoy it.

There are many other good points, but to make your meetings effective, implement as many as you can.

In a recent issue of Top Producer magazine, an article was written by Linda Smith about how agricultural managers are dealing with the Gen X and Gen Y generation.

I know that being a parent of 4 Gen Y boys that you need to deal with them differently from people from my generation (the baby boomers).

In dealing with Gen X workers, we need to realize that it is much more important for the boss to be a mentor or coach to their Gen X employees than just the “BOSS”.  If not, you will lose these workers extremely fast.  We also need to realize that Gen X are not wrong in this approach, but rather, this is what is important to them.  If we try to change them, we will fail.

For Gen Y workers, they have more of an entitlement mentality due to receiving trophies from simply participating in sports as kids and receiving stuff from their parents instead of time.  When they enter the work force, this transition from college can be tough on them.

They are more willing to accept authority, however, they are not really compliant.  They are results oriented, not process oriented.  Also, we need to realize that this generation grew up communicating more by text than face to face.  Therefore, it is unrealistic to restrict or eliminate their use of e-mail and texting. 

They want a coach and to be part of a successful team.  Make sure to be that coach for them.

 Our CPA firm deals with many newly formed businesses each year.  When two or more people get together to form a business, it is almost like a boyfriend and girlfriend getting together for the first time.  They are usually fairly giddy with excitement over the new venture and look forward to the business being there forever.  However, like many human relationships, many of these unions will end in divorce and it can be painful.

I like to remind my clients that they need to be extremely diligent in building in a rip cord in case the business does not work out.  Just as in parachuting for the first time, the rip cord is designed to get you to the ground safely when things do not always work out.

In your business agreement, you need to make sure to document what will happen in the following situations:

• What happens if one of the partners becomes disabled or dies?  Will you use life insurance to take care of these situations?
• What happens if one or more of the partners goes bankrupt?
• What happens if one of the partners decides to leave the business?  Are the remaining partners required to purchase the interest?  If so, what is the price and terms and how is it determined?  What if the parties can not agree on the price, how is that resolved?
• What type of restrictions are built in to the transfer of interests?  If not handled correctly, you may end up new partner that you did not know about or want.

These are just some of  the issues that need to be built into the “rip cord” wording to make sure that it works.  Remember, in these situations it is almost always better to design the rip cord up front than to try to come up with the right one when it is too late.

One of the shows that I have taped on my DVR each day is AgDay.  It comes on in the morning at 6 am and when I get home from work, that is usually the first thing that I watch on TV.  The parent of AgDay, Farm Journal Media has launched a new monthly TV show in conjunction with Pioneer Seeds called Legacy by Design.  It is hosted by my friend Kevin Spafford and the first inaugural show is on AgDay today. 

I look forward to watching the show and see how it evolves over time.  The Legacy by Design site is dedicated to helping farmers transition their farm operation from the current generation to the next or the ones after that.  As our farmers are aging, many of the children that used to hang around and farm are no longer doing that.  It is nice to see the ones that are.

Keep up the good work Kevin and staff and let’s see how the show grows.

Many dairy and other farmers will need to make a decision this year that they may not have had to make for several years.  I would say almost all dairy farmers for 2009 will have a tax operating loss and it may be substantial.  With a net operating loss, the tax laws allow you in most years to  either carry it back for two years or carry it forward for up to 20 years.

However, for farmers they can carry back their net operating losses for up to five years and if they have losses from other businesses for 2008 or 2009, they can carry those losses back for up to five years.

You need to review your actual income tax paid for the last five years.  You will need to determine the amount of tax actually paid and the overall tax bracket that you were in for each year and in total for the appropriate years.

• You need to estimate what your income tax bracket will be over the next few years.  In general, if the prior years overall tax bracket is 15% or less and you expect to be in the 25% or higher bracket going forward, it makes more sense to carry it forward.
• You need to review whether you took advantage of farm income averaging in those years and whether you will take advantage of it going forward. 
• If the loss is very large and you need the cash, carry back the loss and what is left over can still be carried forward to 2010 and beyond.
• You can elect to carry the non-farming loss back three, four or five years or the normal two.

If you make no election, then the loss is automatically carried back two or five  years.  To carry it forward, you must make an election with the tax filing.

Here is a link to the IRS website dealing with the net operating loss rules for farmers and other related farm tax publications and links.