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5 Areas to Monitor to Manage Financial Risk
With less bullish crop prices and a possible leveling off of land values, keeping close tabs on financial risk is more important than ever.
Taking steps now to manage risk can safeguard against adverse consequences coming from the possibility of further downturns in prices and land values, compounded by ever-present production uncertainties.
A look at the past gives cause for action.
“Aside from differences in interest rates, we have some economic similarities right now with what was going on in the 1980s,” says Norm Dalsted, longtime agricultural economist at Colorado State University.
“Then, like now, land values were high and crop prices were strong, causing some farmers to pay too much for land,” he says. Some paid too much for machinery, as well.
“An economic downturn came in the 1980s, and it spelled the end of a lot of producers who were not able to cash-flow their operations,” he says. “Right now, it’s hard to pay as much as $9,000 an acre for irrigated land and make the purchase cash-flow with a corn price of $4 a bushel. For a lot of producers, that’s the price at which they’ll just break even.”
On the positive side, Dalsted sees today’s farmers tending to manage financial risk in ways that can help ward off economic disasters like those happening during the 1980s.
“Farmers have gone through these experiences before,” he says. “Certainly, older farmers tend to be more conservative than younger producers. Farmers have been very cautious about using the extra funds they’ve earned in the last few years from high crop prices.
“Some have put money away,” he notes. “Some, who bought land at high prices, did it with cash on hand. Depending upon how large a down payment they made, they might still cash-flow with lower-price crops. They still need to be cautious and make sure the operation cash-flows, and that they don’t get overextended or overleveraged.”
5 practical areas
Risk can be managed by monitoring five practical areas of business and production:
• Equipment purchases. In particular, Dalsted suggests careful reappraisal of decisions to purchase equipment as a means of reducing tax liability by expensing out the investment in the year of purchase.
“That will indeed serve to reduce current tax liability, but you still have to make the payments on the equipment,” he says. “Make sure that future profitability and net income can service the payment schedule.”
• Cost of production. Lower prices for some crops paired with continuing high input costs increase financial risk. Finding ways to manage levels of inputs reduces risk.
• Marketing. Implementing creative marketing strategies in order to realize increased earnings from production reduces risk by shoring up profit margins.
• Financial tools. “Develop an accurate cash flow statement for financial planning,” says Dalsted. “Look at your previous operating year and see how cash flow has been performing.”
Develop an accurate balance sheet and profit-and-loss income statement. The balance sheet will also show equity, and trends in the growth of equity, along with trends in net worth.
If you’re seeing an increase in net worth, you can interpret the significance of this trend by comparing it with trends in owner equity.
“Determine whether or not the growth in equity comes from increases in profit or from increases in the value of assets, such as land,” says Dalsted. “A sustainable growth in equity is one coming from profits in your business rather than from appreciating land values.”
• Financial performance. Financial ratios reflect business performance. Developing and monitoring these ratios (see accompanying story on previous page) can forewarn of excessive financial risk. Trends in the ratios show financial strengths and weaknesses in the business areas of liquidity, profitability, solvency, and financial efficiency.
“One thing you can learn, for instance, from a financial efficiency ratio is your turnover rate on profit,” says Dalsted. “This helps you look at the income you generate in a year and evaluate the turnover rate relative to investment. If you have a low profitability rate of only .5%, for instance but it turns over monthly or every two weeks, that translates into a high rate of return such as you might observe in a dairy operation.”
Agricultural enterprises typically don’t provide a high rate of turnover, but the example illustrates the use of a financial efficiency ratio in examining the relationship between profitability and turnover rate.
“In order to best manage risk, you need to educate yourself and continually update financial management techniques,” says Dalsted.