Are you using your tax return to track your operation’s expenses? If so, you’re probably not getting the full picture. Most farmers are good at tracking the money that comes in and goes out, with the goal of filling out tax returns and farm income statements. However, there are non-deductible costs that won’t appear on any end-of-the-year tax forms, but will still affect your bottom line. With the ag economy facing challenges and many operations seeing their working capital position tightening, there is no better time to examine all expenditures.
Above all, pay special attention if you think you’re making money, but your working capital position continues to decline. This can be a key indicator something isn’t adding up in your operation’s finances. There are three major areas that often house hidden costs for farmers: family living expenses, principal payments and asset efficiency and labor costs.
Pay your family a salary
Families keep an eye on large expenses, like home mortgages and car payments, but all costs of living should be tracked. Smaller withdrawals for everyday expenses can easily balloon if not properly controlled. Before you know it, your operating loan could actually be financing your family purchases. Over time, seemingly inconsequential costs can make a dent in your balance sheet; but are invisible, because they aren’t stated on the farm’s tax forms.
A better method for controlling the cost of family living is to think of your family budget as a salary or stipend paid out from the operation. The best way to do this is to cut a single monthly check to the family and put it in an account separate from all operational expenses. This way, the cash your family has on hand is finite and it’s also much easier to track how much your family spends annually.
Principal payments and asset efficiency
All term debt principal payments are paid from cash left over after living and income taxes are paid. What does that mean? Let’s look at a simple calculation using just the schedule F from the tax return. We will keep it simple and assume cash accounting:
In this example, the operation is showing taxable income and net earnings after income taxes and living is paid, but cash flow is negative. This calculation is the beginning piece of what lenders refer to as a debt coverage ratio, or DCR. This negative cash flow transfers directly back to the working capital on the balance sheet. Additionally, if you choose to pay cash for any capital assets in the year using this example, 100 percent of the cash used for the purchase reduces working capital.
Be wary of the Section 179 trap. If you purchased a new tractor and chose to fully depreciate it in the purchase year using the 179 Deduction, but borrowed money to buy the tractor, you may have reduced your ability to manage your tax expense the following year. Using the example above and assuming $75,000 of section 179 depreciation was used when the tractor was purchased, you gave away your depreciation tax shelter and now must generate enough net earnings (after tax income) to cover the principal payment on the loan going forward. The table below shows impact on cash flow for the following year assuming the only difference is the lower depreciation and the resulting tax expense.
Labor and equipment are tied together
The employees you need are directly tied to the equipment you have. An extra combine means your operation needs an additional driver and maybe an additional tractor and cart and semi or two with each needing an operator. Too much or underutilized equipment will have a trickledown effect and result in your operation spending more than necessary. While labor costs will be present on the farm income statement, the cost of unnecessary labor will not be stated. Think of capital as finite. Every dollar you invest in equipment and labor is a dollar that can’t be invested in land or other assets, or used to build working capital.
Fortunately, there are many ratios which can be used as a general guide to help you plan for labor. Depending on the kind of operation you own, these ratios can be based on how many head of cattle you have, the bushels your operation produces, etc. In addition to standard labor models, there are a few other questions you may want to consider: Does my operation need all the equipment it has? Is the operation making enough net income to support all the family members currently working on it? Are there ways production could be more efficient that could ultimately reduce labor needs? If you haven’t done so, it may be worth investing in a workflow software that can help with more efficient tilling, planting and harvesting. Any labor-related question can be a tough call for any farmer, but as margins continue to tighten, it is worth reassessing.
If you’re noticing your working capital position or margins declining, take care to assess the above situations. There are many costs that can have a negative impact on your balance sheet that may not be apparent when completing a tax return. Cutting your family one monthly check, revisiting the true costs of your assets and reassessing labor can each go a long way to ensure your operation’s financial health.
For additional financial tips, insights and perspectives, visit the Farm Credit Mid-America website.