Earning money never goes out of fashion.
In a previous blog I discussed paid-in capital as a source of equity. It is typically the first source of equity to appear on a farm's balance sheet. But, it is not generally reliable as a source of regular additions to owner's equity after business start-up.
Related: Is your equity growing or shrinking?
Earned equity, on the other hand, has the distinction of being a reliable source for building owner's equity year after year on well-managed farms.
Net income earned during the farm operating year translates into earned equity at year-end. Revenues and gains increase owner's equity, while expenses and losses reduce owner's equity.
These account balances are typically summarized in an account named "retained earnings" on the balance sheet. The balance in this account represents the total of earned income retained in the business since its beginning.
It is extremely important to measure exactly how much of the change in total owner's equity each year is attributable to change in retained earnings.
Since the changes in fair market values of land and other assets (unearned equity) can fluctuate dramatically year to year, always separate this amount from the change in total owner's equity attributable to earned equity, so that management opportunities are more visible.
Earned equity is reduced by owner withdrawals. For young farmers, more earned equity retained in the farm business early in one's career can really make a difference in one's potential lifetime earnings and wealth accumulation.
All farm owners should carefully consider the relationship between annual accrual-adjusted net income and owner withdrawals.
In my experience two things are certain: successful farm businesses do a very good job of adding to retained earnings in most years and of mitigating the risks of owner's equity losses in every year.
Brought to you by Farm Financial Standards Council. The opinions of Alan Miller are not necessarily those of Farm Futures or the Penton Farm Progress Group.