Financial Management for a Small Agribusiness A training manual Asst. Prof. Najibullah HASSANZOY July 14, 2013 About this Manual This training manual is designed for female agribusinesses running their own small home-based agribusiness. The manual provides essential concepts relating to financial and accounting affairs of a small agribusiness enterprise. Its contents are made simpler so as to facilitate understanding of the audience in question. About the Author The author is an assistant professor of agricultural economics in Kabul University. He has obtained his B.Sc. in the field of agricultural economics & extension from Kabul University, and his M.Sc. in the field of agricultural economics from a recognized university of India. In addition to teaching various courses at Kabul University, he has worked on various positions (manager, consultant, training facilitator, and instructor) with different non-governmental and international organizations. Contact Information: Mobile: 0093 (0) 771695956 1|Page Email: hassanzoyn@gmail.com 1. Introduction Starting and running a new agribusiness requires, among others, adequate financial resources. If an agribusiness is to be profitable, it should have sufficient financial resources. Remember the old saying, “it takes money to make money.” Money is required in every area of an agribusiness, including payments for land, buildings, equipment, livestock, crops, and operating expenses. Personal savings and credit are the two main sources of financing an agribusiness enterprise. Small farmers can hardly save, therefore, they need credit to finance their agribusiness. Majority of afghan farmers are small, conventional and subsistence characterized by small holding size, low productivity, lack of access to improved agricultural technologies, lack of access to credit on reasonable terms, limited information, no or negligible marketable surplus, severe problems in marketing of their products, and so on. Hence, small farmers are in dire need of support and help from government, private sector, and international community. Entrepreneurs accepts risks in starting a new business venture with a purpose to make a profit. Running a business involve various transactions (buying, selling, etc.) and operations to meet the business objectives. Keeping accurate records of business transactions is vital to the success of an agribusiness venture. These records allow tracking of the financial position and profitability of an agribusiness. 2. Need for Credit In the agricultural industry, financing is needed in three areas: fixed expenses, operating expenses, and startup expenses. Fixed expenses are items that can be used over and over for a long period of time, incurring the same price (expense) each year. Examples of fixed expenses include land, buildings, machinery and equipment, tools, and fixtures. Usually a large amount of money is borrowed for fixed expenses. Operating expenses cover everything needed to run a farm, ranch, or agribusiness. The amount of money needed depends on the size of the operation. For farmers, operating expenses are figured on yearly or seasonal basis. A wheat growing farmer would need money to purchase seed, fertilizer, and chemicals and to pay workers. Startup expenses are payable before the business 2|Page begins operations. Examples of such expenses include registration fees, incorporation expenses, and costs for the development of a site. Startup expenses do not include the initial cost of land and other fixed items. Afghan famers do not have access to credit on reasonable terms, and often lack information regarding sources of credit. Farmers, therefore, obtain necessary amount of money from local moneylenders on high interest rates. This could be one of the major hindrance in front of agricultural development. Credit allows farmers to: increase production; improve the quality of what is produced; access improved agricultural technologies; and revise operations to make them more profitable. 3. Three Fundamentals of Credit There are three credit fundamentals each starts with the letter R. Hence, in credit there are three R’s: returns, repayment, and risk. 3.1. Returns: the main reason for borrowing money is to increase net returns and make a profit. An agribusiness manager must carefully choose among the best alternatives when considering credit. Money should not be borrowed based on quick, thoughtless decisions. 3.2. Repayment: agricultural lenders expect their money to be repaid in full plus interest. It is crucial for an agribusiness venture to determine its ability of repaying loans. Priority should always be given to loans that have earning capacity. For example, borrowing for a dairy cows would take priority over borrowing for automatic feeders to replace hand feeding. 3.3. Risk: borrowers with strong assets can take on more risk than those with few assts. It is only reasonable that lenders tend to favor individuals in the agricultural industry who have enough stability to absorb a potential loss. 4. Rational Credit Principles Applying the following principles, wisely, can lead to success and profitability for an agribusiness and farmers: 1) Use credit for productive purposes – purposes that increase income. 2) Limit borrowing on unfamiliar enterprises. 3|Page 3) Use credit where it will generate the highest return within reasonable risk limits. 4) Know your own business situation. 5) Keep debt in line with income and repayment capacity. 6) Shop for loans and select a dependable lender. 7) Be businesslike, honest, and fair in credit dealing. 5. Types of Loans A loan is basically a contract between borrower and lender. Loans usually fall into three borrowing timeframes: short-term, intermediate term, and long term. 5.1. Short-term loans are distinctive in that their terms are normally one year or less. The main use of the short-term loan is to finance operating inputs. Banks, individuals, merchants, and farm credit services are among the suppliers of short-term loans. In business applications, short-term or operating credit assists in purchasing items such as fuel, fertilizer, chemicals, and seed, and in meeting maintenance expenses. Shortterm credit may be the most important type for the survival of an agribusiness, because it finances the everyday operations of the firm, which generate the cash flow in the business. 5.2. Intermediate term loans vary in length from 1 to 10 years. They finance assets that may be depreciable over their expected lives. Farm machinery and equipment, breeding livestock, irrigation systems, and any modernization of farm facilities are examples of these assts. Commercial banks and farm credit institutions are suppliers of intermediate term loans. A lender may require collateral when considering whether to grant a loan. 5.3. Long term loans are loans that extend over 10 years. Purchases of land, buildings, and housing create the need for this type of credit. Typically, the credit instrument used in long-term financing is a mortgage. Businesses and individuals both use mortgages for long-term financing needs. Long term credit is especially important when starting an agribusiness. 4|Page 6. Sources of Credit Generally, formal or informal sources supply loans to individuals and firms. Formal sources include commercial banks, agricultural and rural development banks, and microfinance institutions. Informal sources of credit include local moneylenders, traders, relatives, and friends. Although banking sector is rapidly growing in Afghanistan, yet majority of farmers do not have access to credit on reasonable terms. Hence, framers mostly relies on informal sources of credit. Establishment of agricultural bank will, to a greater extent, solve credit problems of farmers and agribusinesses. At present, some organizations and agencies including ministry of Agriculture, Irrigation, and Livestock (MAIL) provide credit to Afghan farmers and agribusinesses, but their services are limited to a small number of farmers, leaving majority of small and marginal farmers uncovered. 7. Preparing a Household Budget A budget is simply a plan for spending and saving money. That is, an accurate written outline of income and expenses. A good budget is an essential tool in every household. Some of the benefits of a budgets are as follows: 1) A budget puts you in control of your financial future. 2) A budget ensures that you do not spend more than you earn. 3) A budget helps you prepare for major periodic expenses such electricity bill, insurance, and vacations. 4) A budget helps you save money to prepare for unpredictable expenses, such as medical bills, major car repairs, pest control, etc. A household or family budget can easily be prepared by outlining all income, and expenses & savings. The total income must equate total expenditures and savings. Table 1 presents a hypothetical example of a household budget. 8. Preparing an Enterprise Budget An enterprise budget generally has three components: gross income, costs (fixed and variable), and net income. To estimate gross income, a manager should estimate total production or output as well as expected per unit price of output. When making these estimates, assume normal conditions, and be as realistic as possible. For estimation of costs, a manager must determine and list all expected 5|Page fixed1 and variable2 costs. The last step in preparing an enterprise budget is to calculate net income by deducting total costs from gross income. Table 2 provides a hypothetical example of an enterprise budget. Table 1. A hypothetical Example of Household Budget. Household Budget Name: Ms. Shilla Time Period: June - July, 2013 Income (after taxes) 1. Sales Afs 15,000 2. Part time Job Afs 8,000 3. Others Afs 2,000 Total Afs 25,000 Expenditures & Savings 1. Savings (emergency/ opportunity) 2. Food 3. Transportation 4. Furniture 5. Children’s School Fees 6. Miscellaneous Total Afs 8,000 Afs 5,000 Afs 3,000 Afs 4,000 Afs 3,000 Afs 5000 Afs 25,000 Table 2. A hypothetical Example of Enterprise Budget. Enterprise Budget for Strawberries Production (1 hectare) Income Sale of 2500 kg (strawberries) @ Afs 100 per kg Costs (fixed and variable) Seedlings Fertilizer Labor Packages and packaging expense Transportation cost Tractor expense Insurance Miscellaneous Total costs Net Income/Estimated Profit 1 2 Afs 250,000 Afs 2,000 Afs 2,500 Afs 6,000 Afs 25,000 Afs 10,000 Afs 1,500 Afs 15,000 Afs 12,000 Afs 74,000 Afs 176,000 Fixed costs are those that do not change with the level of output such as taxes, insurance, etc. Variable costs are those that varies with the level of output such as fertilizers, seed, fuel, etc. 6|Page 9. Agribusiness Record Keeping Entrepreneurs accepts risks in starting a new venture with a purpose to make profit. Running a business involve various transactions and activities to meet business objectives. Keeping accurate records of business transactions is vital to the success of an agribusiness. Such information allow agribusiness managers or owners to take informed decisions. Given the size of their business and education of the female agribusinesses, a small home-based agribusiness does not require too much complicated bookkeeping and accounting system. A simple and easy bookkeeping mechanism is appropriate for them. The manager of a home-based agribusiness can simply list its business transactions and classify them into two or more categories such as sales, purchases, liabilities, etc. Table 3 provides an example of a record keeping system for small home-based agribusiness. Table 3. A Record Keeping System for Small Home-based Agribusiness. Date May 10, 2013 Transaction Explanation Quantity Purchases/ Costs Purchase of chemicals 120 kg July 4, 2013 Sales/ Revenue Sale of strawberries 20 cartons April 16, 2013 Liabilities/ Loans Loan from Agril. Bank Unit Price Total Amount Afs 30 Afs 3600 Afs 200 Afs 4000 Afs 20,000 10. Essential Financial and Accounting Terms 10.1. Income Income or revenue is the amount of money received in payment for goods or services or from other sources (profits, loans, and credit). Suppose Ms. Shilla owns a small family farm producing strawberries. This year she received Afs 5000 from the sale of her strawberries in the nearby local market. This amount of money constitute Ms. Shilla’s total income. 7|Page 10.2. Expenses Expenses are costs incurred in earning revenue for a particular financial period. To produce goods or services, entrepreneurs have to purchase certain inputs, pay wages, salaries, taxes, rent, etc. these all make business expenditures. In the continuation of the previous example, suppose Ms. Shilla paid Afs 100 for Seedlings, Afs 300 for wages of labor, Afs 200 for chemical fertilizers, and Afs 400 for packages. This total amount of Afs 1000 constitutes her business expenditures. 10.3. Net Income Net profit or income is the amount of money remains after deduction of total expenditures from total income is called net income. Using figures of the previous example, Ms. Shilla’s net income will be Afs 4000 (5000 – 1000). 10.4. Assets Assets are items of value that are owned by the business. Some example of assets are cash, receivables, inventory, equipment, buildings, and prepaid accounts. 10.5. Liabilities Liabilities are business obligations to external parties. Examples of liabilities include accounts payable, notes payable, and mortgages. 10.6. Capital Capital is the investment that the owner has made or put into the business. For example, money used to start the agribusiness is capital. It also include machines, tools, and buildings. 10.7. Owner’s equity/ Net Worth Owner’s equity is the difference between total assets and total liabilities. 10.8. Inventory An inventory is a physical count of all the assets of a business along with their estimated worth, the aggregate of these items is known as inventories (goods, and assets). The term Inventory is also used for the goods that will be sold in the ordinary course of the business. 10.9. Breakeven Point The breakeven point is when total receipts equal total costs (or when your expenditures equal your income), i.e. you neither make profit nor sustain losses. 8|Page 11. Financial Statements Irrespective of the size of agribusiness, the agribusiness owners and managers needs up-to-date financial information to make decisions about future operations. Financial statements provide adequate disclosure of the condition of an agribusiness. The two most common financial statements are income statement and balance sheet. 11.1. Income Statement The income statement is a financial statement showing the revenue, expenses, and net income of an agribusiness. An income statement measures the profit gained by an agribusiness over a given time period. This time period is usually one year, however, monthly or quarterly reports may be desired. Other names for the income statement are operating statement or profit and loss statement. The three major components of the income statement are revenue, expenses, and taxes. The first two components (revenue and expenses) are already defined under one of the previous headings, i.e. essential financial and accounting terms. The difference between total revenue and expenses represents taxable income of an agribusiness. Net income is measured by subtracting fixed income tax expense from the taxable income. Table 4 provides a hypothetical example of the income statement. Table 4. Income Statement of a Hypothetical Agribusiness. Shilla’s Home-based Agribusiness Income Statement for the Year 2012 Revenue (Afghani/Afs) Expense (Afghani/Afs) Sales of seedlings Afs 20,000 Cost of goods sold Sales of strawberries Afs 50,000 Labor Sales of eggs & chicken Afs 15,000 Office expense Sales of dairy Afs 10,000 Input cost Advertising Rent Insurance Others Total Revenue (TR) Afs 95,000 Total Expense (TE) Net Income Before Tax (TR – TE) Income Tax Expense (Income tax = 30%) Net Income (Net Income Before Tax – Income Tax Expense) 9|Page Afs 15,000 Afs 2000 Afs 3000 Afs 10,000 Afs 1,000 Afs 4,000 Afs 8,000 Afs 5,000 Afs 48,000 Afs 47,000 Afs 14,100 Afs 32,900 The above example is simplified to suit the circumstances of female agribusiness owners, possessing small home-based agribusinesses. 11.2. Balance Sheet A financial statement showing all assets and equities (liabilities and owner’s equity) of an agribusiness on a specific date is known as balance sheet. The balance sheet can be prepared whenever the financial information is needed. However, agribusinesses should always prepare a balance sheet at the end of a fiscal period. The three major components of a balance sheet are assets, liabilities, and net worth. A popular accounting equation is that “assets equal liabilities plus net worth” which always holds true. That is why, this financial statement is given the name ‘balance sheet’. The balance sheet has normally two columns. Assets are listed in the left side column while liabilities and net worth appear on the right side column. Assets and liabilities have direct values, whereas net worth has an indirect value for it is calculated from total assets minus total liabilities. The three classification of both assets and liabilities are current, intermediate and long-term, i.e. current assets/ current liabilities; intermediate assets/ intermediate liabilities; and long-term assets/ long-term liabilities. Current Assets and Current Liabilities Current assets are those assets that an agribusiness manager could convert into cash within a 12-month period without disrupting business operations. Current assets include such items as cash, accounts receivable, inventories, and prepaid expenses. Current liabilities are debts that must be paid within12 months of the balance sheet date. Current liabilities include such items as accounts payable, accrued expenses, and any payment due on loans. Intermediate Assets and Liabilities Intermediate assets are those that are normally in service for more than one year, but less than 10 years. During this time frame, management either depreciates, liquidates, or replaces the assets. This group includes machinery, equipment, vehicles, and business furnishings. 10 | P a g e Intermediate liabilities are payable within a time frame of 1 to 10 years. They primarily involve notes that mature within a 10-year period and taxes levied on the sale of intermediate assets. Long-Term Assets and Liabilities Long-term or fixed assets have an expected life or maturity exceeding 10 years. These assets include land, buildings, and other permanent improvements. Longterm or fixed liabilities have maturity periods of more than 10 years. They includes mortgages3 on land and buildings and other long-term obligations. Table 5. Balance Sheet of A hypothetical Agribusiness. Shilla’s Agribusiness Enterprise (Balance Sheet for Jan, 2013) Assets Amount (Afs) Liabilities Amount (Afs) Current Assets Current Liabilities Cash on hand 10,000 Accounts payable 12,000 Savings in bank 8,000 Short term notes Value of grains ready payable 3,000 for disposal 38,500 Accrued rent 4,000 Livestock products 60,000 Accrued payroll 2,000 Fruits, vegetables, Accrued taxes 2,000 fodder and feed ready 8,000 Annual instalments of for sale long-term credit 1,500 Sub-total 124,500 Sub-total 24,500 Intermediate Assets Intermediate Liabilities Dairy cattle 10,000 Livestock loans 8,000 Bullocks 9,000 Machinery loans 15,000 Poultry birds 15,000 Machinery and equipment 15,000 Tractors 175,000 Sub-total 224,000 Sub-total 23,000 Long-Term Assets Long-term Liabilities Land 600,000 Tractor loan 120,000 Farm Buildings 25,000 Orchard loan 25,000 3 Sub-total 625,000 Total of Assets 973,500 Sub-total Total of Liabilities Net Worth or Equity 145,000 192,500 781,000 Mortgage is a loan using a real asset, such as a house or other buildings, as collateral. 11 | P a g e The example of balance sheet provided in table 5 is somewhat complicated for small home-based agribusinesses whose owners or managers are mostly uneducated. Hence, a simplified balance sheet, suiting them, can be prepared by merely listing the assets and liabilities of the agribusiness regardless of whether they are current, intermediate or long-term. References 1. Anthony, Robert N, et al. 2007. Accounting: text and cases (12th edition). Tata McGraw-Hill Publishing Company Limited, New Delhi, India. 2. Obst, Wesley J, et al. 2007. Financial Management for Agribusiness. Landlinks Press, Collingwood VIC 3066, Australia. 3. Pandey, Mukesh and Tewari, Deepali. 2010. The Agribusiness Book: a marketing and value chain perspective. ibdc publishers, Lucknow, India. 4. Reddy, S Subba and Ram, P Raghu. 2010. Agricultural Finance and Management. Oxford & IBH Publishing Co. PVT. LTD., New Delhi, India. 5. Ricketts, Cliff and Ricketts, Kristina. 2010. Agribusiness: Fundamentals and Applications (2nd Edition). DELMAR CENGAGE Learning, USA. 12 | P a g e