Dairy Profitability

Accrual versus Cash basis: What does it mean and why it’s important to dairy farming

by Rebecca White

What is accrual and cash based accounting?

From www.accountingcoach.com :

“Under the accrual basis of accounting, revenues are reported on the income statement when they are earned. (Under the cash basis of accounting, revenues are reported on the income statement when the cash is received.) Under the accrual basis of accounting, expenses are matched with the related revenues and/or are reported when the expense occurs, not when the cash is paid. The result of accrual accounting is an income statement that better measures the profitability of a company during a specific time period.”

For example, if you received a shipment of feed in October, 2010 but the bill doesn’t get paid until February, 2011, on a cash basis, that expense would be considered part of 2011 but on an accrual basis, it would be considered part of 2010’s expenses.

Why does it matter? For a business analysis, it’s important to match the expenses with the related income.  The money you spent on feed to make milk in October may not have come out of your checkbook until February, but those expenses need to go with the matching income. In other words, how much money did it take to make money?

Milk checks also need to be accounted for on an accrual basis.  This can be confusing since you receive December’s milk income in the middle of January.  Also, when it comes to milk checks I have often seen dairymen record the net milk price as income rather than the gross milk check as income. Hauling and marketing should be considered an expense.  Your gross milk income should be reported as your income and even though your net check has already taken out the hauling and marketing expenses, on an income expense report, they should be considered an expense.

But why does it matter?

“The only thing a cash-based system truly reports is how much cash is left, but it misses much of the explanation of how and when it was obtained or spent….A cash-based system may seem easier to maintain because all accounting events are tracked by the flow of cash in and out of the business. It’s essentially a checkbook.”

If you only look at the cash based approach to your dairy’s accounting system, you are missing an opportunity to analyze your business and see the true picture of your dairy’s profitability.

Still not convinced that an accurate business analysis is important? Ask your lender- he thinks it’s important. When you want to borrow money, they will look at financial ratios and analyze them to determine if they will grant you a loan. Accurately analyzing your business allows you to make improvements and create a stable lending opportunity.

Example

Below is an example showing just milk income and feed expenses in August on a cash or accrual based accounting system.  Even with this very simple example, there can be a huge difference between the methods. If you track Income Over Feed Costs (IOFC), the accrual basis is the only way to know how efficient you are at producing milk during that month.

What is Profitability?

by Rebecca White

The definition of profitability from acountingcoach.com is:

“A word to describe whether a company is able to earn more revenues than expenses.”

Sounds simple enough. Is your dairy profitable? Was your dairy profitable this past month? This past year? The past five years?

Dairy farm profitability is more complicated than whether you have money in the checking account at the end of the month or not. An Income Statement or a Profit and Loss Statement for a period of time (usually for a one-year period) determines if a dairy farm is profitable. It reports all revenues and expenses and the net income.

Another important financial statement for your dairy is the Balance Sheet. This will list all your assets and liabilities and is used for other indicators of profitability.

Other Measures of Financial Health Common on Dairies

There is more than one way to size up the financial health of a dairy operation. Here is a short list of measures or indicators of profitability and each topic area will be explain in more detail in following blog posts to come!

Cost of production: How much does it cost you to produce one hundred pounds of milk?

Debt per cow: how much debt does each cow have to carry?

Financial ratios: Return on Assets (ROA), Asset Turnover Ratio (ATR), Operating Expense Ratio (OER), Debt: Asset

Where do I Start?

If you haven’t been involved with a profitability assessment of your dairy operation before, it can seem overwhelming. Ask your accountant or loan officer for an explanation of your income statement and balance sheet. Usually, loan officers develop balance sheets for their clients before a new loan is granted. Income Statements use information from your Schedule F from your farm income taxes or from your accounting software. Click here to find out how.

More resources can be found on our website at www.das.psu.edu

For more information about profitability assessments, visit our Managing for Dairy Profitability website

Questions? Comments? Please feel free to contact us directly or leave a response below.