By: Dr. Kohl
The great commodity super cycle has brought high levels of prosperity, particularly to the grain sector of agriculture. Yes, economic moderation is now in motion and few analysts can predict its extent and duration. Emerging nations’ economies, biofuel and ethanol mandates, Federal Reserve policy and weather are several of the catalysts for change. While economics is uncertain, one fact remains constant: Those who plan, develop strategies, execute them, monitor results and tweak the business as field conditions change have the odds in their favor. Now let’s examine some of the top priorities for every producer’s game plan.
Cost of Production
Starting off, it is critical to know the cost of production. This cannot be stressed enough because it is the foundation beneath any successful game plan. In today’s world of multiple farm enterprises, costs need to be examined by enterprise. This ensures that capital, resources and management can be allocated to their highest and best use. The key is to examine different levels of returns using various cost, price and yield assumptions. In the next two years, examining land cost and rents will be a critical variable for success. The good times created some bad habits, such as putting aside budgeting basics. Budgeting will not be an option, but a requirement going forward. Approximately one in ten producers nationwide knows their cost of production. Even amongst the elite managers at the Executive Program for Agricultural Producers (TEPAP), fewer than 50 percent conduct this critical management analysis.
Second, conduct a resource assessment including land, machinery, livestock and, yes, human resources. Moderating economic times will require focus and shedding unproductive assets. A flight to quality land with reasonable landlord expectations will become a theme, particularly if the economic moderation lasts multiple years. Analogous to an athletic team that goes through a rough patch, focus, discipline and “back to basics” will be the mantras of the day.
Third, utilize variance analysis as a tool for monitoring financial results. That is, compare your projected cash budgets to actual results on a monthly or quarterly basis. Focus on the five largest expenses and top components of revenue. If you have a relationship lender or advisory team, ask them to provide alternatives, counsel and ideas of how to tweak your business for a high level of performance. Do not fall into the trap that many investors experienced in the stock market decline. With the market going downward, monthly and quarterly statements were put into a file and never opened, compared to the eagerly awaited statements in a bull market. Whether it is a bull or bear market, monitoring and tweaking strategies and actions should be a very high priority.
Liquidity, Liquidity, Liquidity!
The top half of the balance sheet will be an important focus in financial analysis. Know your current ratio, net working capital and working capital to expense or revenue ratio. Link your risk management plan (i.e. grain in the bin or livestock for sale) to your working capital strategy. What is the true amount of working capital that can be generated within 60 to 180 days without disrupting normal operations? How does true working capital match debt service requirements throughout the year? Maintain a cash reserve of one year’s debt payments, or two months of average expenses, as a rainy day fund of cash in the bank. This quick, convertible cash will allow you to navigate the white waters of profitability and cash flow, and also position the business to take advantage of discount buying opportunities. The proof in the pudding will be a manager’s ability to keep this mental discipline in liquidity and cash management regardless of the economic cycle.
Debt Coverage Ratio
The time-tested debt coverage ratio will need to be monitored. Simply put, it is cash available for debt service divided by the actual debt service requirement. Good managers attempt to maintain 150 percent coverage ratio, or a 50 percent fudge factor. The key is to examine the various growth, budgeting and capital expenditure strategies using price, cost and production scenarios. Another factor impacting the ability to pay will be increased income tax obligations as a result of reduced incentives on depreciation, along with surtaxes on many items.
Monitor living costs and withdrawals from the business. Good times created bad habits in family living consumption and nonfarm capital expenditures. Farm family living data finds the difference between the highest and lowest one third of family living expenses is approximately $60,000. That is a considerable amount of money that could be used for debt service and financial reserves should the worst-case scenario play out. Family living budgets from Nebraska Farm Business, Inc. and the FINBIN database can be excellent models to help develop your game plan in this area.
Finally, part of management discipline is surrounding yourself with good people. That is, suppliers, lenders, employees, other managers and mentors will be an essential sounding board. Do not get sucked in with the lowest interest rate from a Johnny-come-lately lender in the marketplace. Select a lender that is not just a “yes” or “no” lender, but a “what if” lender who will confirm what you do well, and also suggest areas for improvement.
Let the record speak for itself. FINBIN data since 1995 for crop and livestock enterprises suggests that the top 20 percent of producers earned 10 percent or greater return on assets, while the bottom 20 percent earned 1 percent or negative returns. The group you will be included in is your choice. The protocols outlined above move the odds in your favor in this moderating economic climate.