My next-door neighbor here in Virginia just inherited her family’s farm in Oklahoma. The land has oil and gas royalties and the checks are rolling in. While gasoline prices are increasing and she has to pay more at the pump, she likes the oil price increases, which result in fatter royalty checks! I cautioned her to spend and invest the windfall income wisely, especially since she is taking early retirement as principal at the local school.
This story leads to follow-up questions I received after a recent webcast conducted for bankers. Here is the situation:
We have some questions about analysis of past profitability. Our bank’s trade area is located in the middle of an oil field. Our economy has never been this strong. Consequently, real estate values have had double-digit increases for the past six to eight years, with 15-20% increases the past two years. We have put a lot of focus on earned equity analysis to analyze profitability. We would like your opinion on the following:
Should we exclude oil lease income (non-recurring) from earned equity?Yes. Oil lease income – if non-recurring – is a one-time windfall, and should not be included in earned equity, particularly for the farm or ranch business. This is a one-time shot, which can distort true farm or ranch profitability.
Should we exclude oil royalties (recurring) from earned equity?Even if oil royalties are a stream of income, you could possibly develop a separate enterprise called “energy” and include it in earned net worth. My contention here is that a producer can get a distorted view of profitability generated from the farm or ranch vs. the energy enterprise, altering business-management and risk-management decisions for the total business.
Should we exclude ag land sales (non-recurring) for commercial development from earned equity?Yes, income received from land sales for development would definitely distort true profitability of the farm or ranch. One only has to travel to Florida, Arizona or Nevada, to see all the farm and ranch real estate problems in which “land in transition” or land that was supposed to be developed when the markets were red hot is now selling for 50¢ on a dollar or less.
How should non-farm wages be handled in earned equity analysis?
Approximately 70% of farms report non-farm wages or Schedule C or K income from other businesses. This income is often used to supplement the farm business, but the true measure of success of a business is the income that it generates. These off-farm wages and income would be included on the personal balance sheet or balance sheet of the other business enterprise owned; however, non-farm wages should not be included in the earned equity analysis of the farm or ranch business.
Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at [email protected]