Analyzing Business Opportunities

Ray Massey

Commercial Ag Program

Reasons businesses fail

• Insufficient liquidity – not enough cash to meet obligations when they come due.

• Insufficient solvency – not enough assets to pay off debts.

• Insufficient profitability – not enough revenue to cover expenses.

Accounting Equation:

AssetsLiabilitiesNet Worth

Financial Objective: increase net worth

Assets- Liabilities

Net Worth

Balance Sheet

December 31, 2007 _

AssetsCurrent

Term

LiabilitiesCurrent

Term

Net Worth (Equity)

Balance Sheet

• Date is critical• Snapshot of the financial health of a business

at a point in time• Provides information regarding questions of

net worth, debt and assets

Balance Sheet

Beginning Balance Sheet Ending Balance Sheet

Asset Asset

Liability Liability

Equity Equity

Profit

Financial Fact:

Gross IncomeExpensesNet IncomeFamily WithdrawalsChange in Net Worth

Financial Feat: Increasing Net Worth

Gross IncomeExpensesNet IncomeFamily WithdrawalsChange in Net Worth

Balance Sheet

Beginning Balance Sheet Ending Balance Sheet

Income Statement

Revenue

- Expense

Net Income

AssetAsset

LiabilityLiability

EquityEquity

Income Statement

• Looking at a period of time (1 year)• Important to distinguish between

– cash inflow and outflow – Income and expenses

• Helps manage production, finance and marketing

• Provides information on productivity

Financial Statements

• Aid in tracking progress toward goals• Provide information for making decisions

which promote achieving goals

Ratio Analysis

• Return on assets– ROA = (Net income + Interest) / Total Assets

• Return on Equity– ROE = Net income / Total Equity

• Leverage – the relationship between ROA and ROE

Relationship Between ROA & ROE

Return on Assets

Return on Equity D/A = .5; i = 10%

D/A = 0.15

.10

.05

-.05

-.10

-.15

-.15 -.10 -.05 .05 .10 .15

Cost Concepts

• Fixed and Variable Costs• Cash and Non-cash Costs• Sunk Costs

Fixed and Variable Costs

• Fixed Costs - those not affected by how much an asset is used.

• Variable Costs - those which are proportional to how much an asset is used.

Fixed Costs

• Cost per unit of output decreases as quatity of output increases

• DIRTI 5– Depreciation– Interest– Repairs– Taxes– Insurance

Variable Costs

• Cost per unit of output remains constant with the quantity of output.

• Examples– Feed– Veterinary and Medicine– Fuel– Labor

Which of the following costs are fixed and which are variable?

• Purchased Feed• Repair on Equipment• Maintenance of Buildings• Bull Purchase• Vaccinations

Average Fixed and Variable Costs

Total Fixed and Variable Costs

Cash and Non-cash Costs

• Cash Costs - costs incurred when inputs are purchased for production

• Examples– Wages– Purchased Feed– Fuel– Supplies

Cash and Non-cash Costs

• Non-cash Costs - implicit costs which do not require a present outlay of cash when the input is used.

• Examples– Unpaid Family Labor– Interest on Owner’s Equity– Depreciation

Sunk Cost

• A cost which has been incurred already.• A sunk cost can be fixed or variable

– Depreciation is a fixed sunk cost– Feed is a variable sunk cost once the feed has

been fed.

Necessary and Postponable Costs

• Necessary Costs - costs associated with essential functions

• Postponable Costs - costs which are critical but which may be postponed for a period in order to save a current cash outlay.

Which of the following costs are necessary and which are postponable?

• Purchased Feed• Repair on Equipment• Maintenance of Buildings• Bull Purchase• Vaccinations

Partial Budgeting

• Additions

– Added Returns

– Reduced Costs

• Subtractions

– Added Costs

– Reduced Returns

Partial Budgeting Examples

• Expanding or Contracting Herd Size• Purchasing or Leasing Equipment• Renting or Purchasing Additional Land• Changing Technology

– Organic vs conventional production– Compost vs fresh manure production

Partial Budgeting and Liquidity

• Depreciation is no longer an added cost• Interest is cash interest rather than an

opportunity cost of interest• Determine ability to make loan payments

Partial Budgets and Risk

• Look at the worst case scenario• Consider interaction with other enterprises

– Labor Demands– Equipment Demands

• Long run or Short run Perspective– Prices– Life of Assets

Risk

• “I have seen something else under the sun: The race is not to the swift or the battle to the strong, nor does food come to the wise or wealth to the brilliant or favor to the learned; but time and chance happen to them all.”

Ecclesiates 9:11

Sources of Risk

• Production Risk – risk associated with having less than anticipated yield

• Price Risk – risk associated with having less than a target price

• Financial Risk – risk associated with having insufficient cash flow

• Legal Risk – risk of liability• Human Risk – risk associated with

human/employee judgement

Economic Principle: Risk Return Tradeoff

• Higher returns accompany higher risks• Manage Risk - do not avoid risk• Manage risk by

– Gathering pertinent information– Taking safe decisions – livestock futures– Paying someone else to take the risk from you –

livestock options and other insurance

Analyzing Decisions Accounting for Risk

• Define the possible states of nature– Calving percent of 70%, 80%, 90%– Drought: yields = 1 ton hay, 2 tons, 5 tons

• Determine different actions to take– Stocking rate– Herd health

• Estimate outcomes associated with different actions given different states of nature.

• Make a choice

Decision Making Criteria

• choose action with highest expected return– ignore risk– weighted for probability of outcomes

• mean-variance analysis - choose action a, if returna > returnb and variancea < varianceb,.

• Safety first (or maximin) – choose action with highest minimum outcome

• Shoot for the Moon (maximax) – choose action with highest maximum outcome

Stock moderately

State High rainfall Average rainfall Low rainfall

Receipts $95,630 $95,075 $92,625

Expenses

cattle 84000 84000 84000

forage 2900

supplement 600

interest 3000 3000 3000

veterinary 430 430 800

miscellaneous 200 145 325

Total expenses 87630 87575 91625

Return to land, operator labor, management and capital

8000 7500 1000

Stocking Rate Example

Stocking Rate ExampleDecision

State Stock lightly Stock moderately

Stock heavily

Probability

high rainfall 5000 8000 14,000 .3

average rainfall 4500 7500 6,000 .6

Low rainfall 4000 1000 -5,000 .1

Stocking Rate DecisionDecision

State Stock lightly Stock moderately

Stock heavily

Probability

high rainfall 5000 8000 14,000 .3

average rainfall 4500 7500 6,000 .6

Low rainfall 4000 1000 -5,000 .1

Average 4500 5500 5000

Weighted average

4600 7000 7300

Keys to Decision Making

• Major on the major• Gather pertinent information• Make a decision or plan• Write out the plan• Have someone keep you accountable to the

plan

Sources of Risk: Production Risk

• Select low production risk enterprises• Diversify business• Maintain cost flexibility• Use risk-reducing production practices• Invest in extra machine capacity• Diversify farm operation geographically• Negotiate land lease arrangements• Maintain resource reserves• Purchase crop insurance• Obtain additional information

Sources of Risk: Market Risk

• Hedge on futures market• Insure using options market• Sell by forward contracts• Spread product sales over time• Maintain product and harvest cost flexibility• Select low-price risk enterprises• Diversify business• Negotiate land lease arrangements• Forward price production inputs• Obtain more outlook information

Sources of Risk: Financial Risk

• Keep adequate liquidity• Maintain credit reserve• Negotiate longer loan repayment periods• Hold safe solvency position• Develop land leasing strategies• Incorporate to limit risk• Obtain more accounting information

Sources of Risk:

• Technology Risk– Maintain flexibility– Keep informed of new developments– Lease rapidly changing technology

• Legal Risk– Maintain insurance program– Keep informed on new regulations– Hire custom and contract work

Sources of Risk

• Human Risk– Plan back-up management– Plan for loss of an employee– Maintain insurance program– Plan for estate transfer– Education and training