March 15, 2014. How to Evaluate a Capital Purchase Tools and ideas to help make a financial decision. 2.

March 15, 2014

How to Evaluate a Capital Purchase

Tools and ideas to help make a financial

decision.

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The Decision Making Model

Before making a major purchase decision, ask yourself the following questions:• Why do you want to make this purchase?• Can you manage your operation more

efficiently instead of making a capital purchase?

• Where is your business in its lifecycle?

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The Decision Making Model

• What is the state of your industry? – Depressed, stable, or growing?

• How strong is your management team?– Management is an important element of your

business.• How does your need for financing mesh

with your business plan? – If you don't have a business plan, make

writing one your first priority!

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What’s a SWOT Analysis?

Tool to help you evaluate the:

Strengths, Weaknesses,

Opportunities, and Threats (SWOT)

of your business

Every member of your team should be involved in the process!

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S.W.O.T.

Strengths

Weaknesses

Opportunities

Threats

Internal Strengths Weaknesses

External Opportunities

Threats

S.W.O.T.

For each weakness or threat, there should be an off-setting strength or opportunity to compensate.

If this is not the case, then these areas need to be addressed.

Strengths

• Considered mostly Internal• What do you and your family or

management team bring to your business?

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StrengthsExamples

Internal element• Low-cost producer

– Financial Plan• Competent and reliable employees

– Resource inventory• Marketing niche

– Marketing plan• Expertise in production

– Production plan & resource inventory (skills)

Weaknesses

• Generally considered Internal• These are the factors you will need to

address to run a successful business

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WeaknessesExamples

Internal element• Highly leveraged

– Financial plan• Lack of experience in the industry

– Mentor, education• Not utilizing futures market

– Marketing plan• Inadequate facilities or machinery

– Resource inventory• Are there siblings fighting over family

land?

Opportunities

• Considered mostly External• What opportunities are available to your

business?• Advantageous choices and directions for

the business.

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OpportunitiesExamples

External element• Are there new technologies that

would lower costs?• Will diversification of enterprises

increase profit?• Can my operation command a

competitive edge?

Threats

• Considered mostly External• Threats from outside your business that

will directly affect you• Have very little control over them

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ThreatsExamples

External element• Ethanol explosion to a cattle

feeder• Drought causing water shortage• Unforeseen competition (local or

foreign)• Regulatory Changes

Financial and Management Benchmarks

• Know your financial benchmarks• Equity• Liquidity• Efficiency Ratio

• Know your management benchmarks• Cost of production• Credit Score• Risk Management• Business Plan

Measurement Tools:

• Easy to Use• Comprehensive and meaningful• Accurate• Appropriately calculated

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Equity Position

Total Farm Equity ÷ Total Farm Assets(Total Farm Equity is the Total of Farm Assets minus the Total of Farm Liabilities)

Example:$1,000,000 (total assets) - $600,000 (total liabilities) = $400,000 (equity)

$400,000 (equity) ÷ $1,000,000 (total assets) = 40% Percent Equity

You own 40% of your assets

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Liquidity

Working Capital ÷ Total Expenses(Working Capital is Current Assets minus Current Liabilities)

Example:$300,000 (current assets) - $200,000 (current liabilities) = $100,000 (working capital)

$100,000 (working capital) ÷ $400,000 (total expenses) = 25% Liquidity

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Efficiency Ratio

Total Expenses (minus interest minus depreciation) ÷ Total Revenue

Example$400,000 (Total Expenses) - $50,000 (interest & depreciation) = $350,000 (operating expenses) ÷ $500,000 (total revenue) = 70%

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Key Ratios & PracticesGuidelines Only - - These can vary by lender and/or commodity

Metric Green Yellow Red

Equity Position >65% 35-65% <35%

Liquidity >50% 20-50% <20%

Efficiency Ratio <70% 70-80% >80%

Credit Score +700 650-700 <650

Business Plan Written and Review Annually

Partial PlanVerbalized

None

Know Cost of Production By Enterprise Farm Ranch Overall

None

Risk Management All Components Some None

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Why “Positive Cash Flow” is So Important…

1. Provides funding for business expansion Cash from operations should support at least 25% to 40% of costs related to expansion

2. Enables discretionary equipment purchases or improvements to property and facilities

3. Creates flexibility for management decisions

4. Limits reliance on creditors

Case Study Analysis ExerciseHelp Tom and Jane become more confident about whether or not to make this land purchase by doing the following:• Perform a SWOT analysis• Complete assessment of the key financial ratios• Complete assessment of management

benchmarks • Decide if Tom and Jane should or should not

purchase the property

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Meet the Smith Family • The Smith family has operated a hay

operation for over 15 years.• The family withdraws about $60,000 each

year for family living.• The operation is located in a rural area, but

urban city is close by.• Tom and Jane have two children (ages 20

and 17), both whom help out on the farm and have shown interest in coming back after college.

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Meet the Smith Family (continued)

• Jane works off the farm for an accountant with take home pay of $20,000 plus health, dental and other benefits that extend to the whole family.

• Tom completes a cash flow budget each year and Jane uses QuickBooks to input their expenses and income and reconciles each quarter.

• Their neighbor Sally wants to sell 50 acres (planted in corn) for a sale price of $300,000.

• This additional land should be able to generate a net income after all costs of $50,000

• Bank financing is available for $270,000

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Financial & Benchmarking Tom & Jane SmithBefore Purchase

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Key information from the case study is as follows:

Balance Sheet Current Income Statement Current Other Information

Current Assets $300,000 Total Revenue $500,000 Jane's Credit Score 790

Non-Current Assets $700,000 Interest Expense $25,000 Tom's Credit Score 690

Total Assets $1,000,000 Depreciation $25,000

Operating Expenses $350,000 Crop Insurance? Yes

Current Liabilities $200,000 Total Expenses $400,000 Hedges & Options? No

Non-Current Liabilities $400,000 Net Farm Income $100,000 Knows Cost of Production? Yes

Total Liabilities $600,000 Non-Farm Income $20,000 Business Plan? Thinking about it

Family Living Expense ($60,000)

Net Worth $400,000 Income Taxes ($30,000) Debt Service $50,000

Total Net Income $30,000

Financial & Benchmarking Tom & Jane Smith

After the Purchase

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If Tom and Jane purchase the property, key financials will change as follows:

Balance Sheet Post Purchase Income Statement Post Purchase Other Information

Current Assets $270,000 Total Revenue $600,000 Jane's Credit Score 790

Non-Current Assets $1,000,000 Interest Expense $50,000 Tom's Credit Score 690

Total Assets $1,270,000 Depreciation $25,000

Operating Expenses $375,000 Crop Insurance? Yes

Current Liabilities $225,000 Total Expenses $450,000 Hedges & Options? No

Non-Current Liabilities $645,000 Net Farm Income $150,000 Knows Cost of Production? Not by Enterprise

Total Liabilities $870,000 Non-Farm Income $20,000 Business Plan? Thinking about it

Family Living Expense ($60,000)

Net Worth $400,000 Income Taxes ($30,000) Debt Service $100,000

Total Net Income $80,000

Your Task:• Review the Equity Position Ratio• Review the Liquidity Ratio• Review the Efficiency Ratio• Perform a SWOT• Decide if Tom & Jane should purchase the

property.

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Financial Ratios• Equity Position

– Before Purchase 40%– After Purchase 31%

• Liquidity– Before Purchase 25%– After Purchase 10%

• Efficiency– Before Purchase 70%– After Purchase 63%

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Management Benchmarks

• Knows Cost of Production __________

• Credit Score __________

• Risk Management __________

• Business Plan __________

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S.W.O.T

Strengths (internal) Weaknesses (internal)

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S.W.O.T

Opportunities (external) Threats (external)

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Financial & Management Benchmark

Benchmark Measure Green Yellow Red Tom & Jane Before Purchase

Tom & JaneAfter Purchase

Equity Position >65% 35-65% <35% 40% 31%

Liquidity >50% 20-50% <20% 25% 10%

Efficiency Ratio <70% 70-80% >80% 70% 63%

Knows cost of Production

By Enterprise

Overall None

Credit Score >700 650-700 <650

Risk Management All Components

Some None

Business Plan Written Verbalized None

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