# Reading your farm accounts A free short course from Farm CFO by Clunes Rural. 5 lessons, about 25 minutes in all. No sign-up. Read your profit and loss and balance sheet with confidence, see why depreciation isn't cash, and work out EBIT, EBITDA and equity. Who it's for: Pig, cattle and sheep farmers who get a set of accounts from their accountant each year and want to understand what it says. You'll be able to: - Read a profit and loss and know what each part means - Read a balance sheet and work out your equity - Explain why depreciation is a cost but not a cash payment - Work out EBIT, EBITDA and interest cover from your own accounts ## Lesson 1: What the profit and loss tells you Once a year your accountant hands over a set of financial statements. The page most people turn to first is the profit and loss. It's also called the P&L, the income statement or the operating statement. They all mean the same thing. The profit and loss covers a period of time, usually the financial year. In Australia that runs from 1 July to 30 June. It answers one question: over that year, did the business earn more than it cost to run? ## The three parts **Income.** Money earned from what you sell. On a livestock farm that's pig, cattle, sheep or wool sales, plus things like agistment fees. **Costs.** What it cost to earn that income. Some costs go up and down with the size of the herd or flock, such as feed, animal health and freight. These are called variable costs. Others stay much the same whatever you run, such as rates, insurance and permanent wages. These are called overheads. **Profit.** Income less costs. If costs are bigger than income, it's a loss. ## Things that catch people out - **Stock on hand.** Farm accounts often include a line for the change in livestock numbers or value over the year. Selling down the herd can make income look high, and building it up can make it look low. Ask your accountant how it was worked out in your accounts. - **Depreciation.** This is a cost in the profit and loss, but no money leaves the bank for it. Lesson 3 covers it. - **Loan repayments.** The interest is a cost. The part that pays off the loan, called principal, isn't in the profit and loss at all. - **Drawings.** The money your family takes out for living costs often isn't shown as a cost either. It depends on how the business is set up. ## Looking back and looking forward Your accountant's statements are prepared mainly for tax, and they look back at a year that's already over. During the year you can keep your own simple profit and loss each month or quarter. These are called management accounts, and banks often ask for them. Putting your actual figures next to your budget each month shows you where the year is drifting while there's still time to act. ## What to look for Read the total income first, then the total costs, then the profit. Then compare each line with last year. A big jump in one line, such as feed, is the question to ask your accountant or to think through yourself. If a word stumps you, our [farm finance glossary](https://farmcfo.com.au/guides/farm-finance-glossary) explains it in plain English. ### Worked example **An invented farm, for learning only.** A beef cattle business has a year ended 30 June with cattle sales of $620,000 and agistment income of $10,000. Total income is $630,000. Its costs are feed and animal health $150,000, wages $120,000, fuel and repairs $70,000, rates and insurance $40,000, depreciation $60,000 and interest $70,000. That's $510,000 in total. Profit is $630,000 less $510,000, which is **$120,000**. Notice what isn't there. The business also paid $50,000 off its loans, and the family took out drawings for living costs. Both left the bank, but neither shows up in the profit. Download the budget vs actual template: https://farmcfo.com.au/downloads/farm-cfo-budget-vs-actual.xlsx ### Check your understanding 1. What period does a profit and loss usually cover? Answer: A period of time, usually the financial year from 1 July to 30 June. A profit and loss adds up income and costs over a period, usually a financial year. The balance sheet is the report that shows a single date. 2. A farm repays $50,000 of loan principal during the year. Where does that show in the profit and loss? Answer: It doesn't show in the profit and loss. Principal repayments reduce the loan, so they aren't a cost in the profit and loss. Only the interest is. The money still leaves the bank, which is one reason cash and profit differ. 3. Feed costs jumped from $90,000 last year to $150,000 this year. What's the most useful thing to do? Answer: Find out why, for example higher prices, more stock fed or a dry season. A big change in one line is a signal. Knowing the reason tells you whether it will happen again, and the bank will ask the same question. ## Lesson 2: The balance sheet: what you own and what you owe The profit and loss covers a year. The balance sheet is a snapshot on one day, usually 30 June. It lists what the business owns, what it owes, and the difference between the two. ## Assets: what you own Assets are things of value the business owns. On a farm that's land and buildings, livestock, plant and machinery, stored feed, cash in the bank and money owed to you. Money owed to you is called debtors. An example is a sale where the agent hasn't paid you yet. Assets are often split into two groups. **Current assets** are expected to turn into cash within 12 months, like cash, debtors and stock you plan to sell. **Non-current assets** are kept for longer, like land and machinery. ## Liabilities: what you owe Liabilities are debts. On a farm that's term loans, the overdraft, equipment finance and bills you haven't paid yet. Unpaid bills are called creditors. Liabilities are split the same way. **Current liabilities** are due within 12 months, like the overdraft, creditors and this year's loan repayments. **Non-current liabilities** are due later. ## Equity: what's left Equity is what you own less what you owe. If you sold everything and paid every debt, equity is roughly what would be left. Lesson 5 looks at it more closely. ## Book value and market value Here's the part that confuses people. Your accountant's balance sheet often shows assets at what they cost, less depreciation. That's called book value. Land bought 20 years ago might sit in the accounts at a fraction of what it would sell for today. The bank cares about what assets are worth now. That's why it often asks for a separate statement of assets and liabilities at current values. Our [assets and liabilities template](https://farmcfo.com.au/downloads/farm-cfo-assets-and-liabilities.xlsx) sets one out. Use fair values you could explain, not the best price you'd hope for. ## What to look for - Is the overdraft deeper than last year? That can be a sign the business is spending more than it earns. - How much debt is due in the next 12 months, compared with your current assets? - Has total debt gone up or down over the last three or four years? Look at the balance sheet next to the profit and loss. A farm that makes a profit but whose debt keeps climbing is worth a closer look. Our [farm finance words](https://farmcfo.com.au/templates/farm-finance-words) card has these terms on one page. ### Worked example **An invented farm, for learning only.** A sheep business lists its assets and liabilities at current values on 30 June. | Assets | Amount | |---|---:| | Land and improvements | $4,200,000 | | Sheep | $600,000 | | Plant and machinery | $400,000 | | Cash and debtors | $50,000 | | **Total assets** | **$5,250,000** | | Liabilities | Amount | |---|---:| | Term loan | $1,500,000 | | Overdraft | $150,000 | | Equipment loan | $100,000 | | Creditors | $50,000 | | **Total liabilities** | **$1,800,000** | Equity is $5,250,000 less $1,800,000, which is **$3,450,000**. Put another way, the business owes about 34 cents for every dollar it owns. Download the assets and liabilities template: https://farmcfo.com.au/downloads/farm-cfo-assets-and-liabilities.xlsx ### Check your understanding 1. What's the main difference between a balance sheet and a profit and loss? Answer: The balance sheet is a snapshot on one day, while the profit and loss covers a period. The balance sheet shows what you own and owe on one date. The profit and loss shows income and costs over a period, usually a year. 2. The accounts show land at $900,000, but similar land nearby sells for far more. What's the likely reason? Answer: The accounts show book value, based on what the land cost, not what it's worth today. Accounts often record assets at cost. That's why the bank asks for a statement of assets and liabilities at current values. 3. Which of these is a current liability? Answer: The farm's overdraft. Current liabilities are due within 12 months. An overdraft is short-term finance, usually reviewed each year, so it's treated as current. Land is an asset, not a liability. ## Lesson 3: Depreciation, and why it isn't cash A new tractor lasts many years. It wouldn't make sense to count its whole cost in the year you bought it, so the accounts spread the cost over its working life. That spreading is called depreciation. ## How it works Say a machine costs $200,000 and is expected to last 10 years. One simple way is to count $20,000 a year as a cost, for 10 years. Accountants follow set methods and tax rules, so the figure in your accounts may be worked out differently. Check with your accountant how yours is calculated. Depreciation applies to things that wear out, like machinery, vehicles, sheds, yards and fences. It doesn't usually apply to land. ## Why it isn't cash The money for the tractor left the bank when you paid for it. Or it leaves bit by bit, as you repay the loan you bought it with. Depreciation in later years is just the accounts recording the wear. No cheque goes out for it. So when you work out cash, you add depreciation back to profit. That's why a farm can show a small profit and still have more cash than you'd expect. ## Why it still matters It's tempting to think depreciation doesn't count. It does. Machinery wears out and has to be replaced. If the money is spent on other things every year, there's nothing put aside when the tractor dies. Treat depreciation as a rough guide to what you need to reinvest each year just to stand still. ## The mirror image: loan principal Loan principal repayments work the other way. They're cash going out, but they aren't in the profit and loss. So to get from profit to cash: 1. Start with profit. 2. Add back depreciation, because it isn't cash. 3. Take off loan principal, because it is cash. 4. Take off drawings, and any spending on new machinery or land. The [repayment schedule](https://farmcfo.com.au/tools/repayment-schedule) splits each loan repayment into interest and principal, so you can see both parts. Our [debt schedule template](https://farmcfo.com.au/downloads/farm-cfo-debt-schedule.xlsx) keeps all your loans on one page. ## What to look for Compare depreciation with what you actually spent on machinery and improvements over the last few years. If spending has been far below depreciation for a long time, your gear is getting older and a big bill is on its way. It's better to plan for it in the budget than to meet it in the overdraft. ### Worked example **An invented farm, for learning only.** A piggery makes a profit of $50,000 for the year. That's after $20,000 of depreciation on its feed mill. During the year it also paid $35,000 off the loan it used to buy the mill. To keep it simple, the family lives on off-farm income, so there are no drawings. | | Amount | |---|---:| | Profit | $50,000 | | Add back depreciation | $20,000 | | Cash from the year, before loan principal | $70,000 | | Less loan principal | $35,000 | | **Cash left** | **$35,000** | Two things moved in opposite directions. Depreciation lowered profit but not cash. Principal lowered cash but not profit. Try the repayment schedule: https://farmcfo.com.au/tools/repayment-schedule ### Check your understanding 1. Why is depreciation called a non-cash cost? Answer: Because no money leaves the bank for it in the year it's recorded. Depreciation spreads the cost of something already bought over its working life. The cash went out when it was bought, not each year it's depreciated. 2. A farm's profit is $40,000 after $25,000 of depreciation. Before loan principal, drawings and purchases, how much cash did the year bring in? Answer: $65,000. Add depreciation back to profit: $40,000 plus $25,000 is $65,000. Then you'd take off principal, drawings and purchases. 3. A farm's depreciation is $60,000 a year, but it has spent only $10,000 a year on machinery for five years. What does that suggest? Answer: The machinery is getting older and a big replacement bill is likely. Depreciation is a rough guide to the wear on your gear. Spending far less than that for years usually means replacements are building up. ## Lesson 4: EBIT and EBITDA in plain words Bank managers and accountants use two words that sound like a sneeze: EBIT and EBITDA. They're just versions of profit, with certain costs added back. ## EBIT EBIT stands for earnings before interest and tax. You start with profit before tax and add back the interest bill. Why take interest out? Because it shows what the farm itself earns, before it pays for its debt. Two farms could run exactly the same way and have very different interest bills, just because one borrowed more. EBIT lets you compare the farming, not the borrowing. ## EBITDA EBITDA stands for earnings before interest, tax, depreciation and amortisation. Amortisation is like depreciation, but for things you can't touch, such as a licence. Most farms have little or none. EBITDA is EBIT with depreciation added back. Because depreciation isn't cash, EBITDA is closer to the cash the business earns from farming in a year. ## How the bank uses them The bank often uses EBIT for **interest cover**. That's EBIT divided by interest, and it tells you how many times profit covers the interest bill. If interest cover is 3 times, profit could fall a long way before the farm couldn't pay its interest. The bank often starts from EBITDA for **debt service cover**. That compares the cash earned with interest and principal together, often after taking off drawings. Banks work these out in different ways, so check the wording in your own facility letter. Our course on [how the bank looks at your farm](https://farmcfo.com.au/learn/how-the-bank-looks-at-your-farm) goes further. ## Working it out yourself Find three numbers in your profit and loss: 1. Profit before tax. 2. Interest. 3. Depreciation. Then: - EBIT = profit before tax + interest - EBITDA = EBIT + depreciation ## Watch for one-off items One-off items can blur the picture. A big insurance payout or the sale of a block can lift profit in one year. When you compare years, note anything unusual, and ask your accountant if you're not sure what a line is. The bank will usually look past one-offs to what the farm earns in a normal year, so it helps if you do too. The [bank ratio check](https://farmcfo.com.au/tools/bank-ratio-check) does these sums for you and shows the main ratios side by side. ### Worked example **An invented farm, for learning only.** A piggery's profit and loss shows: - profit before tax: $150,000 - interest: $60,000 - depreciation: $80,000 EBIT is $150,000 plus $60,000, which is **$210,000**. EBITDA is $210,000 plus $80,000, which is **$290,000**. Interest cover is $210,000 divided by $60,000, which is **3.5 times**. In other words, earnings before interest could fall by $150,000 before they no longer covered the interest bill. Interest cover only looks at interest, though. Debt service cover, in the bank course, adds principal repayments. Try the bank ratio check: https://farmcfo.com.au/tools/bank-ratio-check ### Check your understanding 1. How do you get EBIT from profit before tax? Answer: Add back interest. EBIT is earnings before interest and tax, so you start with profit before tax and add the interest back. 2. Why is EBITDA closer to cash than EBIT? Answer: It adds back depreciation, which isn't a cash payment. EBITDA is EBIT with depreciation and amortisation added back. Those are non-cash costs, so the result is closer to the cash the farm earns. 3. A farm has EBIT of $180,000 and interest of $60,000. What's its interest cover? Answer: 3 times. Interest cover is EBIT divided by interest. $180,000 divided by $60,000 is 3 times. ## Lesson 5: Equity, and what makes it go up and down Equity is the part of the business that's yours. It's total assets less total liabilities. If a farm owns $5 million and owes $2 million, equity is $3 million. ## The equity ratio A dollar figure on its own doesn't say much, because farms come in all sizes. So people also look at the **equity ratio**: equity divided by total assets, shown as a percentage. In the example above it's $3 million divided by $5 million, which is 60%. A higher equity ratio means you own more of the business yourself and owe less. Each lender has its own view of what's comfortable, and it depends on the cashflow too. A farm with lower equity but strong, steady cash can be a better borrower than one with high equity that loses money. ## What makes equity go up - **Profit you keep in the business.** Profit that isn't taken out as drawings builds equity. - **A rise in asset values**, such as land going up in value. Paying down debt from profit is part of the first point. The profit builds equity, and using it to repay debt means you owe less. ## What makes equity go down - **Losses.** - **Drawings bigger than profit.** If the family takes out more than the farm earns, equity falls, even in a year that shows a profit. - **A fall in asset values**, such as land or livestock prices dropping. ## Earned growth and paper growth It pays to know which kind of growth you've had. If equity rose only because land values went up, the farm hasn't earned anything extra. The land just got dearer. If values fall later, that equity can go just as fast. Growth from profit you've kept is the kind you can rely on. ## Why the bank cares Equity is your buffer. It stands between the bank's loan and a loss if things go wrong. That's why the bank works out your equity at current values, not book values, each time it reviews your loans. ## Track it yourself Once a year, fill in a statement of assets and liabilities at fair current values. Our [assets and liabilities template](https://farmcfo.com.au/downloads/farm-cfo-assets-and-liabilities.xlsx) sets it out. Write down your equity and equity ratio, and compare them with last year. Then split the change into profit kept and changes in values, so you know what really happened. The [bank ratios card](https://farmcfo.com.au/templates/bank-ratios) has the equity ratio and the other main ratios on one page. ### Worked example **An invented farm, for learning only.** This is the sheep business from lesson 2. It started the year with assets of $5,250,000, debts of $1,800,000 and equity of $3,450,000. Its equity ratio was 65.7%. During the year it made a profit of $120,000, and the family took $90,000 in drawings. So it kept $30,000 in the business. Then the land was revalued from $4,200,000 to $3,990,000, a fall of $210,000. Debts stayed at $1,800,000. Equity at year end is $3,450,000 plus $30,000 less $210,000, which is **$3,270,000**. Assets are now $5,070,000, so the equity ratio is **64.5%**. The farm earned its way forward by $30,000. Lower land values took $210,000 off. See the bank ratios card: https://farmcfo.com.au/templates/bank-ratios ### Check your understanding 1. A farm owns $6 million and owes $1.5 million. What's its equity? Answer: $4.5 million. Equity is what you own less what you owe: $6 million less $1.5 million is $4.5 million. 2. A farm makes a profit of $80,000 and the family takes $110,000 in drawings. Leaving asset values aside, what happens to equity? Answer: It goes down by $30,000. Drawings came to $30,000 more than profit, so the business is $30,000 worse off and equity falls by that much. 3. Equity rose $400,000 this year, all from higher land values. What's the sensible way to read that? Answer: It's growth on paper, and it could reverse if land values fall. A rise in values isn't profit. It can be useful, but it can go as fast as it came, and each lender makes its own call on how much to lend. ## Next step Farm Health Check: https://farmcfo.com.au/health-check ## Sources - [Study Australia (Australian Government), Tax and superannuation: the financial year runs from 1 July to 30 June](https://studyaustralia.gov.au/en/work-in-australia/work-rights-and-responsibilities/tax-and-superannuation) General information only, not financial, tax, legal or credit advice. These courses are not nationally accredited training.