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Farm financial management: Keeping the pencil sharp

 

University of Kentucky College of Agriculture, Food and Environment

 

LEXINGTON, Ky. — A significant trait found in top-performing farm managers is having a focused approach toward efficiency and a sharp pencil. Two things top managers focus on are working capital and cash flow. The current agricultural production climate warrants all producers to take an even closer look at costs and returns.

 

So far, 2014 has shown some signs of concern for grain producers with commodities trading at or below the cost of production, while livestock and dairy producers, especially cow/calf operations, may see an opportunity to improve farm equity. Regardless of what enterprise mix constitutes your farming operation, prudent farm financial management is the cornerstone of ensuring that your operation can weather a storm or efficiently allocate net worth to be productive in future years. This article will look at the importance of having adequate working capital as well as ways to address cash-flow issues.

Working capital is the difference between current assets and current liabilities, and is generated from net farm income (NFI). Current assets include cash and marketable grain/livestock inventories that will be sold within a year. Current liabilities are those that are due within one year such as operating notes, yearly principal, and accrued interest payments on term debt. Increasing working capital is important so that your operation can better withstand short-run profit shortfalls while taking advantage of opportunities as they arise.

NFI is the difference between total income and total expense, including gain or loss on capital asset sales. The difference can be thought of as the amount returned to owner equity, management, and unpaid labor. There are only four places that NFI can go: 1.) family living or partner withdrawals; 2.) income and social security tax payments; 3.) increases in assets; and 4.) decreases in liabilities through principal payments, all of which affect net worth. Number three above is where positive NFI can be used to increase working capital by retaining returns in liquid assets. Positive NFI can also be applied to number four above and still increase working capital by reducing liabilities.

With shrinking margins in grain commodities, many producers will have a lower NFI for 2014 relative to the most recent years. Concern arises when debt servicing and family living expenses are based on years of relatively high, and in some cases record-breaking, incomes. There is a good chance that balance sheets completed at the end of 2014 will not show as high of an increase in cost-basis net worth as years past. This is where managers must sharpen their pencils and take time to analyze their operations in detail. For producers who find that they are having cash-flow issues because their working capital is not sufficient, consider the items below:

 

  • Debt Structure — Do you need to restructure your debt load? If you have too much current debt, it may be advisable to restructure it and shift more to term debt. This will help alleviate some cash-flow concerns.
  • Asset Management — Are you maximizing your assets? Think about the “big ticket items” such as tractors and combines. Are these fixed costs being spread over as many acres as possible? Or, were you hoping to “grow in to them?” If the asset is not being maximized, it may be time to sell and replace it with a more appropriately sized asset. This decision needs to be analyzed carefully. Take into consideration gains/losses and the potential for accelerated depreciation recapture before making this decision. Livestock operations need to look at underperforming assets as well. It may be time to replace or cull underperforming assets.
  • Asset Acquisitions — Is now the best time to be purchasing new machinery and buildings? Remember, those payments are due each year, regardless of your NFI. Do not let your eyes become bigger than your balance sheet. Keep the ego and emotions in check when making these decisions.
  • Cost reduction — Are your operating costs as low as possible? Is it possible to make repairs as opposed to purchasing new equipment? Review other costs, especially overheard costs, and determine if reductions can be made.
  • Downsizing — With shrinking margins, is it time to give up marginal land? Remember, each farm needs to be analyzed and cash rent needs to be looked at on the margins. In other words, the revenue generated off each farm needs to be compared to cost associated with generating that revenue. Calculating average cash rent for your operation can be very misleading when deciding whether to renew a lease. Be sure to complete an enterprise budget specific to each farm.
  • Cash rents — Is it possible to renegotiate cash rents for 2015, or find less-costly rental agreements?
  • Family living — Family living expenses are arguably as “sticky” as cash rents. These expenses should be analyzed as closely as farm expenses and be adjusted to correspond with NFI.
  • Have a cushion — Having several months of living expenses on hand as well as other liquid assets for the farming operation is not a bad thing. While there is not much return to be earned on these assets currently, self-insuring in this manner will help to safeguard your family and your farming operation against an unexpected event (major repair, illness, etc.)

 

For those producers who may have been dealing with cash-flow issues in the past but are posed to increase profitability in the coming years, be cautious not to forget the lessons learned. Do not let the pencil get dull. While returns may be up for livestock and dairy producers, be judicious in making decisions concerning expanding herds. Be sure to carefully plan and budget any new capital assets to ensure that you will be able to pay for them if the cycle turns down. A great place to start with these decisions is your own detailed and timely kept records. If you need help analyzing these decisions, or find that you have cash-flow concerns, contact your local Kentucky Farm Business Management Specialist and see what the Kentucky Farm Business Management Program has to offer. To find out more, go to www.uky.edu/Ag/KFBM.

This article was written by Jonathan Shepherd, a farm management specialist in the Agricultural Economics Department at the University of Kentucky College of Agriculture, Food and Environment. The article first appeared in the June 27 edition of Economic and Policy Update.