Impacts of financial decisions
Financial Management: Farm Tools for a Low-Profit Environment
Agricultural economists are great sources for market and price expectations, but unexpected events often impact commodity markets. Whether your margins are strong or tight, developing a mindset of continuous improvement regarding your farming operation’s finances will improve your farm’s financial stability when you get an unwelcome surprise from the markets or the weather. Even during higher profit years, a culture of continuous improvement will benefit your farm in the long term. Some of tools below will be helpful when your operation begins to feel pressure.
Assess the stress
It can be difficult to determine if financial stress on an operation will be long term or short term. Before you develop a strategy and take action, first identify the likely duration of the stress.
Short-term stress could be driven by a localized weather pattern hurting your yield but not the overall market price. During short-term stress, you can usually count on long-term price recovery. In these situations, your mindset is to weather the storm. Significant operational adjustments may not be needed.
Long-term stress could be driven by a legislative change, or a consumer base shifting to a new product. If the financial stress looks to be long term, aspects of the farm’s strategy and operations may need to be modified. Improving cash flow, profitability, and working capital for the farm may be critical to maintain financial stability. Significant and more permanent strategic and operational adjustments may be needed.
Prepare a cash flow forecast
If you can anticipate shortages in cash flow or borrowing capacity, you’ll be able to more easily remedy the situation. The farm’s leadership team should prepare a forecast of cash flows and monitor the cash flow of the operation. Using historical results as a base, then adjusting for expected changes in cash flow in the future, a cash flow forecast is a fairly intuitive exercise. Preparing a cash flow forecast with a trusted advisor can add to your organization’s strategic conversation.
If the cash flow forecast shows borrowing capacity is exceeded at any point in the year, develop a plan to improve timing of cash flow (defer expenses, accelerate revenues), reduce operational or capital spending, increase revenues, or simply pursue additional borrowing. Regardless of the action you take, knowing you may have a cash flow challenge in advance improves your ability to manage it.
After you’ve prepared a cash flow forecast, you’ll want to compare it to actual cash flow as the year goes on. Any significant differences should be explored. The investigation into variances improve an operation’s understanding of cash flow and its ability to predict future cash flows. However, the most valuable aspect of a forecast is organizational strategic alignment. When leadership evaluates, agrees to, documents, and reviews the strategic direction of the farm, everyone can make day-to-day decisions that align with the farm’s strategy.
Know your cost of production and control it
Before you come up with a strategy to address the financial stress in your operation, you have to know when a price for your product is profitable. If you produce a commodity, costs are what you can control the most. For a commodity farmer, controlling costs is the primary path to profit. Evaluate the following areas:
- Plan and communicate how the operation tracks costs — All leaders of the farm should understand and agree on how the operations are being measured and evaluated. Determine the key indicators of strategic success and track them. Examples of questions to discuss for cost-tracking include: Are costs tracked by crop? By field? Is a separate cost center used to track equipment costs? How are overhead costs allocated to determine crop profitability? Use simple and well-defined business terms, and ensure employees understand and use them. Accounting structure and financial reporting formats should be aligned with agreed cost-tracking objectives. Remember, what you measure tends to improve.
- Determine if your asset base is efficiently producing revenue — Seek ways to produce more revenue with the same assets, such as increasing production or providing custom work for other farms. Could you produce the same revenue with less assets by selling under-utilized assets or sharing assets with neighbors? Farm tax planning in past profitable years may have prompted year-end equipment upgrades, but make sure the upgrades make good business sense in today’s operation. The Asset Turnover Ratio (ATR) is a simple measurement of an operation’s asset efficiency (below).
- Family living expenses — Tracking family living expenses (groceries, education, clothing, etc.) on a farm is sometimes difficult because of the close connection between farming and family. Separating the financial impact of the living expenses from the operations of the farm is critical to understanding a farm’s true cost of production and profitability.
- Pricing and marketing — When making marketing decisions, be comfortable taking a profit rather than chasing the top of the market. Knowing how profitable a price will be under normal yield scenarios reduces the emotion of marketing decisions. Understanding your cost of production, amount of production already priced, and current expected average price for your production will help to manage pricing risks and make marketing decisions.
- Discuss land rent with your landlord — While land rent is often one of the biggest costs of a farming operation, it may provide the biggest opportunity for savings. Land rent often has some flexibility, especially if there is a long relationship between the landlord and the operator. Where there’s a history of good communication and cooperation managing the land, focus on establishing annual rents at levels that are sustainable in the long-term for both parties. If your landlord relationship isn’t long or deep, now is a good time to start building the relationship and communicating the factors that influence your operations. Impartial sources such as university averages for low, medium, and high productivity soils can be useful references to identify a rental rate that results in profit potential for the landlord and operator.
- Review property tax assets and values — If you own land with multiple structures on it, review the real estate property cards to ensure all structures on the card are still standing. Review the assessed values of existing structures and especially new structures to ensure values are appropriate. If you have personal property tax in your state, review your asset list to ensure all equipment is still owned by the farm. Identify idle, obsolete, or scrapped equipment that could be taxed at lower rates or removed completely.
Ratios and reducing capital spending
Understanding a few useful financial ratios can help you know when to reduce spending. Reducing capital spending can take pressure off cash flow, increase working capital, and improve profitability. Even a one-year reduction in machinery purchases can significantly improve working capital and reduce depreciation expense.
The Asset Turnover Ratio measures how efficiently an operation’s assets are producing revenue. ATR is calculated by dividing gross revenue by average total farm assets. Like many ratios, ATR can vary significantly based on an operation’s decision to purchase or lease assets, and including land in farm assets can significantly dilute ATR. The variability in ATR can make benchmarking against peers less meaningful. But benchmarking against your own operation’s past results can provide a consistent and meaningful measurement of trends.
Working capital is a simple measure of the adequacy of resources available for an operation. Besides being easy to understand and calculate, working capital as a percent of total expenses is easily benchmarked across comparable operations. Working capital is calculated by subtracting current liabilities from current assets, then divide working capital by total expenses. Results around 40 percent are usually strong, while results around 20 percent could be concerning. Reducing capital purchases and paying down operating debt are two ways to quickly improve this measurement.
How we can help
Operating a farm can be difficult even when commodity markets and profitability are relatively stable, but prudent and disciplined financial management can reduce stress and mitigate risk. Understanding your operation’s financial results and status allows you to make decisions with confidence in low-profit environments.
CLA’s agriculture professionals can help you no matter the size or complexity of your agribusiness. We can help you assess your current financial management needs and develop a plan to help you strengthen your operation. The most successful agribusinesses make their decisions armed with knowledge so they can create a reasonable amount of certainty even in uncertain times.