Managing your financial risk is a little like skinny-dipping — you’ve got to protect your assets, and that’s hard to do when you’re not covered.
“When the tide goes out, everybody can see who’s swimming naked,” said MNP agricultural tax specialist Rob Strilchuk (quoting Warren Buffett).
“We had a lot of good years, but when the tide turns in the other direction, we can see situations where it’s going to expose your farm operation to see what’s really happening.”
After a decade of generally strong prices and yields, back-to-back poor harvests and lower prices coupled with high expenses are squeezing many producers, Strilchuk said at a Powering Your Profits event earlier this winter.
“Really what this means is there’s no hiding place when things change,” he said. “But you can protect yourself against situations like this by trying to make sure you’re on top of things ahead of time.”
In order to build a profitable farm that can weather these storms, farmers must focus on strong finances, strong production, and efficient marketing.
“If you improve each one of these things by five per cent, it makes a dramatic impact on your bottom line,” he said.
But fine tuning your finances can be tricky. The first step is to look at your financial statements and determine if you are, in fact, making a profit. That starts with an estimate of gross revenue.
“If you end up only getting $9 a bushel on a 50-bushel-an-acre yield, you’re going to have $450 an acre,” he said. “It’s pretty tight these days at that $450 an acre. We usually have our farmers target $500 an acre gross revenue.”
Excess working capital is critical, he said.
Current Ratio = Current Assets/Current Liabilities
What are current assets?
Cash, savings, prepaid expenses, crops in the bin, growing crops, marketable livestock, accounts receivable, supplies on hand (such as seed, feed, and fertilizer).
What are current liabilities?
Obligations due and payable in the next 12 months such as bills, credit card balances, operating lines of credit, accrued interest, and principal payments due on intermediate and long-term loans.
“If you have decent working capital, it means you’re prepared to make sure you can take on a crop failure or a delayed harvest,” said Strilchuk, who advises using a current ratio (current assets divided by current liabilities).
“If you’ve got a 2:1 ratio, you’re in good shape. But you’ve got to have at least 1.25 times the current assets as compared to the current liabilities,” said Strilchuk. “In other words, you have to have $1.25 in current assets for every $1 of current liability. That’s the minimum.”
Adequate working capital also allows you to take advantage of early sales on seed, chemical, and fertilizer while giving you some flexibility in your marketing.
“If it’s on sale in the month of August and you’ve got great working capital, you’re in a position to take that on,” he said. “When there’s a lot of supply and the price is low, I sure hope that you don’t need the cash to do other things.”
When payments need to be made, then you basically have to sell “no matter what the price,” he said.
Strilchuk said he likes to see farmers have enough working capital to cover half of their operating expenses in the coming year.
And having a buffer zone will be increasingly important as ‘black swan events’ — those unprecedented and unexpected situations such as China’s ban on canola or a once-in-100-years flood.
“Can you weather the storm? The banks watch these types of events in order to determine whether or not your operation can sustain something that’s negative,” said Strilchuk. “As times get tougher, their appetite for risk might go down.”
If you’re feeling more financial strain, you might want to read through your loan agreement.
“Banks aren’t trying to pull a fast one on you,” he said. “Ag is big business, and high dollars of leverage are required to operate these businesses. Do you think they’re just going to have a loose legal agreement for that? You need to read through those agreements and make sure you understand what you’re signing.”
The other thing to do is talk to your lender.
“Banks are looking for information on a regular business if things are tight,” said Strilchuk. “They want to know where you’re at so you can meet your obligations. They want to know if you have that repayment capacity and if you’re leveraged over the right period of time.
“It takes all parties working together to make sure you can meet your operation’s needs.”