Ep. 97 Harvesting Financial Success: Insights on Year-End Financials

Main Topics Covered:

1. Year-End Financials: The episode covers the components of year-end financials, including the balance sheet, earnings statement, and size and scale questionnaire. Nathan explains the importance of these documents in understanding a farmer's financial situation and making accrual adjustments.
2. Cash vs. Accrual Accounting: Nathan provides a brief explanation of the difference between cash and accrual accounting, emphasizing the importance of recognizing inventory and other non-cash items in financial reporting.
3. Lender's Perspective: The discussion includes what lenders look for in year-end financial statements, such as asset valuation, debt changes, and key capital measures like working capital and net worth.
4. Common Mistakes: Nathan highlights common mistakes made by farmers in preparing year-end financials, such as missing names and dates, inconsistent reporting, and not updating asset values.
5. Valuation of Real Estate: The episode discusses how to value real estate on balance sheets, recommending market basis values while being conservative to avoid overvaluation.
6. Impact on Loan Decisions: The importance of detailed and consistent financials in influencing loan approvals and credit limits is discussed, highlighting how they build lender confidence.
7. Business Diversification: The impact of business diversification on credit risk and the importance of documenting new enterprises in financials are covered, with recommendations for separate bookkeeping.
8. Communication with Lenders: The benefits of regular communication with lenders throughout the year are emphasized, particularly in ensuring accurate and up-to-date financials.
9. Use of Financial Data: The episode concludes with a discussion on the importance of using financial data for decision-making and trend analysis, encouraging farmers to engage with their lenders in reviewing financial trends.

 

Transcription

Speaker 1 (00:08):Welcome to AgCredit Said It, your go-to podcast for insights on farm finance and maximizing your return on investment. Join us as we talk to industry leaders, financial experts, and area farmers, bringing you skillful advice and strategies to grow your farm's financial future ag credit setting where farm finance goes beyond the balance sheet.

Phil Young (00:38):Welcome back to AgCredit Said It where we take you beyond the balance sheet of farm finance. I'm your host, Phil Young, and today we're talking about balance sheets as we prepare for year end. Nathan Buzard, credit analyst at AgCredit is our special guest today, so we're going to talk about prepping year end financials for your lender and really why it's important. So welcome Nathan.

Nathan Buzard (00:59):Well, thanks Phil. Nice to join you. You brought a credit analyst in, so I figured you wanted to talk about sports or fast cars or something, but

Phil Young (01:08):Yes, exactly like not.

Nathan Buzard (01:10):Okay.

Phil Young (01:10):Yeah, I'm sorry. Yeah, sorry. Maybe you prepared for the wrong one, maybe. I don't know. Okay,

Nathan Buzard (01:15):Fair enough.

Phil Young (01:16):But we can talk about that at the end if we want to. Yeah, sure. Happy to talk about that.

(01:22):But no, glad you carved some time out for us. I think this is a super important topic that obviously impacts all of our borrowers, and it's one of those things where it's important for our borrowers to do. Some do it well, some need maybe some practice or a refresher, and so this is why we bring in is to kind of shake the rust off of some of our borrowers skills and the why we ask this and why not only does it benefit us, but why it helps them. So wanted to jump in and kind of start right away here, but can you explain what year end financials are and why they're important for both farmers and us as an ag lender?

Nathan Buzard (02:01):You bet, you bet. So when we hear Year-end financials, I think of three primary things, and that's the balance sheet, the earning statement, and then the third item's, what we'd call the size and scale or year end questionnaire that we hand out. So we'll touch on each of those as we go here. We don't expect financial reporting like a publicly traded company certainly, but these three items really form the foundation of our understanding of the farmer situation and kind of brings us up to speed with where they're at. So year end usually means the end of the typical 12 month earnings period for that person or entity. A year end for an entity might be March 31st or June 30th in the case of some say greenhouse operations, but most commonly for our grain and operations, we're looking at calendar year end, December 31st. Obviously that tends to match up also with W2 wage earning statements and income reported on 10 99 statements and such.

(03:14):So 1231 is usually what we're talking about when we say year end. It's also kind of the natural timing in which most of your crops have been harvested, so there's no longer a question of what's that crop worth out in the field. It's generally in the bins by then and either in the bins or converted to cash by then. So 1231 works out for a number of reasons, but the bottom line is we want a balance sheet that's dated whenever the earnings year end occurs, and that's because we then integrate accrual adjustments into our analysis where we take the cash basis earnings. Most schedule afters are cash basis reporting to the IRS. So what we want to do is convert that to accrued earnings, and we usually, ultimately we need the beginning balance sheet of the start of the year and then the ending balance sheet at the end of the year.

(04:15):For a new applicant, we might not have that beginning balance sheet, but over time we start to build up these year end 1231 balance sheets and then we can make accrual adjustments to those balance sheet items that haven't hit the earnings yet. So we're talking grain inventories, accounts receivable, accounts payables, accrued interest, all those items that go up and down from one year end to the next but didn't hit that cash basis schedule left yet. So we will make those adjustments and by doing that, we're again converting cash to accrual and those accrued earnings are really going to show us the reality of the success or the challenges of the earnings for that recent year.

Phil Young (05:07):Okay, nice. Okay. Can you very briefly explain the difference between cash and accrual? I guess why? I mean, just real brief. So I think most guys know the difference, but just as a refresher for someone if they don't know.

Nathan Buzard (05:25):Yeah, essentially cash is you're recording items when you cash that check or when you write that check, you're recording that as income or expense. You are not recording something like say you had really good yields and now you have more grain inventory in the bins, literal bushel quantities larger than you had in the bins the previous year end. The cash accounting is not going to capture that. So that's the value of converting from cash to accrual is, and this is a standard accounting concept, but we're going to recognize that buildup of say, grain inventory and give credit for that if you will.

Phil Young (06:16):Sure. Okay, good. Okay, so as a lender, what are the key components we look for in a farmer's yearend financial statements?

Nathan Buzard (06:27):Again, we mentioned the balance sheet, so we're going to look at that balance sheet. We're looking for the name, just some real fundamental things. Whose balance sheet is this? We want the date and we're going to ask, are the asset values reasonable? The value per bushel, if we're talking about real estate or the real estate values per acre, reasonable values per head of livestock, we're just going down through the asset side and just checking for reasonableness. Does it make sense? We do want as much detail as possible, so don't just put a big lump number for grain inventory. We'd like to see the corn, soybeans, wheat, and whatever else may be out there on grain or feed inventory kind of broken down as detailed as possible. Also, kind of that itemized equipment list and title vehicles prefer to, especially on our ongoing accounts, borrowers that we're working with, we'd like to see that list of equipment entitled vehicles and are we keeping those values updated correctly to market values because while we did see some appreciation in recent years, generally those should be depreciating down over time.

(07:53):We're also asking ourselves, are there any new or deleted assets from last year, say that prior year end balance sheet if we know a farm was sold or a farm was purchased, certainly equipment purchases or sales, those are items we're thinking about and making sure that the balance sheet is reflecting the new situation. Are there any new or paid off debts that might go along with that as well? Then also we're looking at, once we kind of assess the balance sheet for completeness and accuracy, then we're kind of stepping back and looking at the key capital measures. So anytime we say capital, we're thinking balance sheet. So key capital measures might include definitely working capital is one of the headliners and that's your current assets minus current liabilities. So what we'd call kind of the top part of the balance sheet, looking at working capital levels, net worth levels, so total assets minus total liabilities, and then we're looking at owner's equity ratio, so that's net worth divided by total assets, and so we know the higher that ratio is, the less debt there is out there compared to total assets.

(09:20):So those are some of the ratios and measures that we're looking at. Once we feel we've got the balance sheet nailed down pretty well, then onto the earnings. Ideally we are looking to see earnings in the form of federal tax returns with all the supporting statements and forms, and it could even include the depreciation schedule that that would not be overkill whatsoever to see that depreciation schedule in there. If those are not available for the recent earnings year, then we ask for a profit and loss statement for the farm or business, and in theory, we're hoping that's going to ultimately match up with the tax return earnings once we eventually would get the tax return, but we have to be careful sometimes looking at profit and loss statements, they might contain entries that are not just regular income and expense items like capital purchases and sales. So we kind of watch out when we collect a p and l that we're just looking at entries that we expect would ultimately show up on the Schedule F once that's completed later.

(10:36):Let's see. The tax preparer might not include all such items in the schedule right in the eventual schedule F. By the time it gets to schedule F, that should just be regular income and expense items. So if we do have the tax returns, we're simply going to start looking at whose name is on the tax return, and then in the back of our minds we're thinking, do our balance sheet dates match the start and end of this earnings year that's presented in the tax return? Again, usually that's Jan one to 1231. In many most cases we're looking for additional businesses owned by the applicant that maybe weren't in prior tax return years. Sometimes that certainly happens. They'll show up as a new Schedule C or a new entity in the Schedule E pass through section. So that might precipitate some questions or asking for, Hey, we need a balance sheet on this new entity that we didn't know existed yet.

(11:49):We definitely use the schedules and statements that are in the tax return. So we're looking at asset sales and purchases that might've occurred in this recent earnings year, and we're also just big picture thinking about where did the cash go from that sale of that farm, for example, or how did they purchase that combine? If there wasn't a new debt stated on the balance sheet, we might wonder where those funds came from. So we talk balance sheet earnings, and then finally is the size and scale information, and that's where we're asking about acres, farmed tillable acres that you own, and then how many acres are you cash renting and maybe what your sharecrop situation is, what percent of the sharecrop acres are your share? That's going to show up on the schedule F. Basically that size and scale sheet also gets into the types of crops that were planted in a given year.

(13:00):So we get the crop acreage breakdown yields, and then also price per bushel, but yields becomes pretty important. That helps us build a history of what the yield situation on average is for this particular borrower. And then finally we can get into the livestock aspect of things, certainly with a number of head purchased in the year, number of heads sold in the year, and then what those weights and cost per head or cost per pound are on average. So this helps us build a picture of what's happening out there operationally that can't necessarily see from the balance sheet or earnings information. So we could somewhat jokingly say that with excellent consecutive year end balance sheets and really good size and scale data, we almost don't need the schedule F, but we don't say that officially by any means. We need the schedule F, so we still want to see those.

Phil Young (14:06):Nice. Okay. Yeah, the thing you talked about balance sheets and more the details the better, and I think that's something I think that I always make sure when I'm sitting at the borrower, we kind of hammer hammer home. You're not rounded those numbers, you're not using rounded numbers, you're using as close to exact as you can get, and the item about scheduling your equipment and vehicles I think is super important. It's kind of tedious to do, but I think it's always a good point to say, Hey, there's probably no other document that you have where you itemize these things and it's probably you're kind of killing using one burden, two stones or whatever is you probably need to give that to your insurance agent. So you do it with us and it's a great tool just to turn around and give to your insurance agent and say, Hey, here's all that I own and I need to keep it insured.

(14:57):And so you're kind of doing it for two different business relationships there, but from now that we kind of dove into, obviously we talked about the balance sheet, the statement slash tax return and size and scale. In your experience having done this for a while, what's the most common mistakes or oversights you see when someone does their year end financials when they hand it off when a farmer does it or a borrower does it and they hand it off to you, what are some common things you see that are like, ah, there maybe be oversights or just mistakes?

Nathan Buzard (15:32):Yeah, and some of these are kind of like you're implying might be small things, but they can have a big impact. Just little notational items. So one thing might be just lack of names and dates up at the top of that balance sheet, who is this balance sheet for? And as of what date, a balance sheet is just a point in time. Unlike earnings which are over a period of time, that balance sheet is a snapshot at a very certain time. So again, a lot of times we're working at 1231, so we want 11:59 PM at 1231 is the ideal. If you start wandering away from 1231 to December 15th or Jan 15th, there's a whole lot for tax reasons, there's a whole lot of transactions that take place in that two weeks before or two weeks after. And if we're going to kind of reconcile the balance sheet changes to the cash basis earnings, we really need it to be on the same date, so state that date at the top.

(16:43):Another one might be just simply forgetting a new asset or a change in debts a new debt or a debt got paid down ahead of schedule. We would want to clearly see that and kind of relying on the farmer for that information neglecting to cross out an asset that was sold or a debt that no longer exists. Another one might be just not being consistent in reporting things, big valuation changes up or down. Maybe just explain it if you're changing values, big time on real estate I guess comes to mind or that big couple of items of equipment, relatedly, if you never change the value, and I'm thinking equipment and vehicles, any depreciating assets, if those values never change, we'd probably have to start questioning that and ask that equipment list be updated to market. That might be lower. A final one would be if you're updating a pass balance sheet that was provided to you by ag credit, sometimes we'll just see a dash put beside an asset or liability or there's no change to the numbers from the previous year and we look at a three-year-old balance sheet and lo and behold, it's still the same cash, let's say cash and savings.

(18:18):It just never changed. We might just wonder, is the borrower putting the time in to really update the numbers all the way accurately? So if nothing else, it's best to write unchanged or same beside that item. We don't always know what a check or a dash means when we're going through those.

Phil Young (18:43):Yep. Yeah. Do you have a recommendation? I feel like I get this question a lot, Nathan, is what do I value my real estate at? Do I put what stuff the market is? Do I go a little less? What do you recommend to avoid what we call potentially paper, paper inflation on your balance sheet or paper overvaluation?

Nathan Buzard (19:07):You bet. So on the asset side of your balance sheet, we're generally looking for market basis values. A bit of a subset of that is supplies and prepaids. Technically it's the lower of your cost basis or market basis, but big picture, its market basis values on the asset side. So there again important to keep the equipment vehicles kind of what you would get for it in a public transaction. Real estate's a good one. Sometimes we see balance sheets that have the original cost basis of a given farm. We understand why one would do that from a estate planning standpoint and you might have a separate balance sheet where you track it that way from a cost basis standpoint, but for our purposes, we definitely are thinking more market basis. So you would be okay to, you'd be in the right to go ahead and follow the market by and large with let's say your real estate values doesn't mean if there was a recent kind of high ball auction. You don't need to adjust all your real estate up to that necessarily. I think most farmers feel more comfortable being conservative, and so in an increasing valuation market, they'll tend to hang back 10 to 15% on valuation and that would be comfortable with us too to not hit the top of the market but lag it by 10 to 15%.

Phil Young (20:58):Okay. Gotcha. Good answer. Yeah, yeah. How do your end financials influence a lender's decision on loan approvals or credit limits?

Nathan Buzard (21:10):Just short answer would be the more detailed and complete and consistent those financials appear to be, frankly, the less defensive the lender's going to be. We're not going to be sitting there wondering what other bad or good surprises we don't know about. So it just kind of builds confidence from the lender standpoint. It also kind of implies does the borrower know their own numbers as well? So it's just all about confidence building, you might say, from the lender's viewpoint.

Phil Young (21:49):Nice. Yep. I guess we kind of covered this a little bit. Why do we place so much emphasis on year end financials compared to other business documents?

Nathan Buzard (22:02):Again, we're often trying to convert cash basis earnings to accrual, so we're leaning on those year end balance sheets entirely to do that cash basis. Earnings are not an indicator of the success or challenges of a farm in that one given year over the course of a three or four or five year average. Yeah, it's averaging out and you're getting a feel for things, but we want to know in order to keep up with our borrowers in good times and bad, we want to know what their accrued earnings look like in this recent year. And the only way to do that is with those consecutive year end balance sheets. I might've said before also on a grain farm that 1231 date is when most of the crops are no longer in the field, so both the farmer and the lender are working with pretty solid post-harvest numbers. Those bushels are now in the bin or they're converted to cash and savings, or they paid down the line of credit. So things are solidified much better at 1231 versus the middle of October, for example.

Phil Young (23:22):I guess how could regular communication with your lender throughout the year benefit the year end review process?

Nathan Buzard (23:28):Yeah, good question. I'd say with good periodic communication throughout the year, the lender's going to be less surprised by changes to the financial position from one year to the next. There can be some big that occur throughout the year. So it's just kind of keeping us as the lender feeling like we're on the same page as those months progressed through the year. It also helps us ensure that the balance sheets are fully updated when we know about, say that farm that was purchased last spring or that combine that was traded out in the summer. We can make notes in our analysis tool throughout the year, just kind of notating, Hey, that farm was sold last April or what have you, so that by the time we're inputting the new 1231 balance sheet, we're seeing our notes as well and reconciling that with what information we're being given on that new balance sheet and that new year end questionnaire. So now from an earning standpoint, there may be material changes to rented acres, for example, and that can affect all kinds of things, but including whether the revolving line of credit is adequately sized for the new size of the operation certainly can affect our earnings projections also.

(25:04):And speaking of communication, I take the quick opportunity to mention that a challenge that lenders are having, I'd say really since 2020 CO years, many of the tax returns are now getting completed as late as mid-October, so this is a material challenge for egg lenders. Some of that income and expense occurred two January and Februarys ago, it was quite a while ago. So lenders are not going to feel quite as confident when that earnings data is coming in four to eight months later than it used to, you might say. So the fixes either, I think for the borrowers to push on their tax preparers to get those tax returns completed earlier in the year. Barring that, we'll have to ask farmers for a solid profit and loss statement, and while we're waiting on the tax returns, if they can provide a p and l for that year that we're waiting on that, that would help quite a bit, but still there's a lot of good information in those tax returns. If we can push back to getting them in the spring, late winter or spring, it would make everything run efficiently from our standpoint.

Phil Young (26:32):Yeah, it is weird. It does seem like a lot more late completed tax returns and yeah, I would agree with that. Kind of switching gears here, if a farmer diversifies their business, say by maybe adding a new crop or agritourism, or let's say they do a agri related business, they start a new LLC, something like that, throw up a hog barn, they've never had livestock before, how should they document this in their year end financials?

Nathan Buzard (27:05):Yeah, okay. Good question. Yeah, this is definitely one of the questions that we ask on our year end questionnaire, and it's something we would certainly want to know about any sort of new enterprise that borrower is entering into. Sometimes we are not told explicitly about these things, but they might show up as new assets, new debts, or as a new line of income on the p and l or Schedule F, it might show up as a new Schedule C if it's a non-farm business or even as I mentioned before as a schedule, a new pass through entity. So those are the clues we're looking for, but really if we can just be told upfront about it that that's ideal, we wouldn't mind seeing the farmer create a separate set of books for that enterprise. That way both the farmer and the lender can see which enterprises are profitable over time, or if not, maybe some changes need to be made, and that's the discussion that we can have. But if it's just all kind of glommed into the Schedule F, which does happen, and we can understand why, there's a lot of sharing of assets sometimes when you get into the formulated businesses, but it does make it tougher to kind of fare it out which enterprises are profitable and not when it's all combined into one schedule on the tax return.

Phil Young (28:43):Would you recommend, obviously filling out separate balance sheets for maybe your personal asset? You mentioned this a little bit, but if you have a separate LLC doing an LLC balance sheet, your personal, and then every entity you have doing that versus mushing it all together under one balance sheet?

Nathan Buzard (29:01):Very good question. There's no one right answer to that. Sometimes say a farmer certainly puts their land into a trust or an LLC, and that's mostly all that's in an entity. So in that kind of situation, it'd be okay if that LLC that holds all the land was still right there on the personal balance sheet perhaps, and this is more common when it's just a sole member LLC, we'll just keep those assets on the household's balance sheet. But as you get into Multifamilies owning these entities and the entities really standalone and file their own tax returns and such, then we tend to want to see those separated out on a separate balance sheet, whether it's an equipment entity, a trucking entity, what have you. It sort of can evolve into you make that leap and end up putting them on a separate balance sheet.

Phil Young (30:15):Okay. So yeah, kind spin it into what you do. So what impact does business diversification have on the lender's assessment of risk or credit worthiness when you start jumping into these different things?

Nathan Buzard (30:28):Well, I mean certainly diversification can be a positive at tribute to credit risk, providing that the borrower has that management ability to handle multiple enterprises, right? There's only so many hours in a day, and so there's some pros and cons to getting into more things, obviously, but steady earnings from say, residential or commercial rentals or a car wash or a consulting business. I mean, those sources of earnings can certainly help offset the farm risk, which we're seeing here in recent years. And grain farming, obviously, especially for those kind of small to medium sized farms that just have lesser economies of scale than the largest operations, that diversification can be a real plus, certainly can also allow you sometimes to more fully utilize farm equipment, but offering custom services, for example, is a form of diversification. The key is whether that additional enterprise and source of income is covering all expenses, and is it providing a return to the owner's labor and management versus just wearing out equipment, for example.

Phil Young (31:55):Is it probably helpful for someone in your position if they're adding something that's non-grain side, if it's an aggravated business or like you said, rental houses, is it helpful for you for the borrower to put together their own projections for the next year on that side of the business or even the grain side to put together their own projections to give you

Nathan Buzard (32:15):Yes, thank you. It sure is, and especially with non-farm businesses or the further we would get out of an ag related enterprise can become quite helpful to understand what are the rental, how many rental units are in this building, et cetera, and what are the average rents. So yes, it's very valuable to communicate that information. And again, like you said, it might be just a farm related expansion or a new enterprise. So if that applicant or borrower can provide us with a projection for the next one to three years and some of that yield and acres and yield and some of that granular operational information, if nothing else, it shows the lender that, Hey, this applicant's really thinking about this. They've thought it through pretty deeply, and that's meaningful unto itself.

Phil Young (33:25):Nice. Nathan, any last minute thoughts here on this topic? I had one other question, but I wanted to see if you had anything that maybe we didn't talk about that you wanted to share, or

Nathan Buzard (33:40):Good question. Just show that you've done your homework as the farmer or loan applicant, whether it's that putting up a hog barn or getting into some sort of non-farm investment. Just convey everything you can. More information is better. We can work with tighter numbers, tighter results from our analysis if we feel like there aren't going to be any surprises and that the borrower has a firm grasp of what they're doing out there, what risks they might be jumping into. So we've got a lot of impressive borrowers that they know that stuff. It's just as the lender, we'd want to say, feel free to communicate that, and more communication is always better. That's a certainty.

Phil Young (34:40):The last thing I wanted to touch on was the fact that everyone gives us their information. You guys work hard on throwing it together. It's just as much a great tool for us as it is for them to sit down and us to go over it with them and show not only just have us input the data, but here's the results, here's what we're seeing. Here's trend data. The importance of doing it every 1231 every year is because we can look back five years from now and have consistent data and say, Hey, are you growing? Are you increasing your net worth? How's working capital doing over those years? Can you share a little bit about that on the importance of not only us grab it, but also, yeah, this is your data and we can share it back with you. Yeah.

Nathan Buzard (35:31):Yep, yep. You're exactly right. So this turns into not just loan decisions, but valuable conversations on the backend, so to speak. And over time, we are able to, and we do keep track of trends in many of these financial measures, the working capital, the net worth, et cetera, et cetera. So sometimes the process goes pretty quick and we get that loan made for the borrower and roll on. But ideally, we're going to come to the table, both lender and borrower are going to come to the table and look through that financial analysis and just kind of discuss and point out trends and answer questions. So I'd like to, as lenders, I'd like to see us do as much of that as possible. And as borrowers, you could press your lender to make sure they are doing that as well.

Phil Young (36:36):Yeah, use it as a big decision making tool for them. Should I buy this? Should I hold off? Am I growing? Am I increasing earnings? How are my margins? All those things are great discussions to have with your credit. So thank you, Nathan, for joining us today.

Nathan Buzard (36:52):Yeah, my pleasure.

Phil Young (36:53):Really appreciate tapping into your knowledge. You've been doing this for a while and seen a lot of financials. You've seen a lot of balance sheets and done a lot of projections, so it's always good to kind of tap into your wisdom. So appreciate it, sir.

Nathan Buzard (37:05):My pleasure, Phil. Thanks for having me.

Phil Young (37:07):Yep. So I encourage everyone to get with their account officer before year end to turn financials in, ask any questions, make any year end payments, and the earlier you can do these things, the better. And that way it makes sure payments are applied on time and ask for help. We're always willing to sit down and go through that balance sheet together. You don't have to do it by yourself and turn it in. We can sit down with you and fill it out together. But again, thank you guys for listening and we will see you soon on another episode of Ag Credit. Set it we'll, talk again soon.

Speaker 1 (37:47):Thank you for listening to AgCredit. Said It. Be sure to subscribe in your favorite podcast app or join us through our website at AgCredit.net so you never miss an episode.