A growing number of financial advisors are talking a different language today than they were 10 or 15 years ago. Increasingly they see that the financial health of the farm goes way beyond the numbers on the balance sheet or income statement. They know those numbers are underpinned by some basic fundamentals that require sound management if they are to make the farm successful, sustainable and prepared to flex and cope with any situation, good or bad, that it could face.
So, what are those fundamentals?
Paul Hammerton sums them up in just a few words: “healthy finances and internal strength in production based on a sound rotation, informed by good, science-based agronomy.” Hammerton, a farm management consultant with MNP in Swift Current, Sask., then sets out the challenge for today’s farmers. “You need to understand the dynamics of your business, including production potential, the financial structure of the business, the amount of risk that you are potentially exposed to, and how well equipped you are to handle that risk.”
To get to that point is a process that starts, usually, with a review of a farm’s current financial position, and maybe some modelling exercises, says Hammerton.
“We might be doing a budget or using our modelling software to look at what the client intends to do, and planning around that to get to different scenarios,” he says. “Once we load up all the critical information, which is assets, liabilities, operating costs, inputs, farm machinery, land building and financing, and set some parameters around what they want to do, we can see what that might look like for their longer-term average if they hit their targets, or what it might look like if it doesn’t work as well as they’re hoping it will.”
Get the conversation started
As every farmer knows, the growing season, markets and a whole plethora of things beyond their control can affect their operation in any given year, so knowing how well equipped the farm is to handle different scenarios is vital, and leads inevitably to a conversation about risk and how to manage it.
Hammerton begins those conversations by identifying three things that are especially important when assessing risk: the farm’s working capital position (liquidity), its risk ratio (percentage of equity invested in production) and how much debt it is trying to service.
“The first thing we need to know is what is their working capital position? How much do they have available to them in inventory (market-ready produce) and cash, plus any other short-term assets or investments, less any current liabilities, so less any money that’s already spoken for and then, how that net number relates to what it costs them to run the business,” says Hammerton.
As an example, if it costs a farm $1.5 million to run its business, it should ideally have minimum working capital of around $750,000 in place at the beginning of the farming year, and the optimum position is to have the full $1.5 million available. “We’d like them to have 100 per cent of working capital ready and available up front,” says Hammerton. “If they don’t, life is riskier for them than if they do.”
In reality, few farms have that kind of working capital available to them at all times, especially as they invest in expansion or are transitioning to the next generation, so that’s where the risk ratio comes in — how much of their net worth (total assets less total liabilities) is invested in producing their crop.
“It’s important to know what the farm is worth and what percentage of that are they putting out there each year to grow a crop,” says Hammerton. “If the farm is putting out $1.5 million to grow a crop and it’s worth $5 million, they’re putting 30 per cent of their net worth into production, and that’s a fairly typical number. Some farms can drop that number to 10 to 15 per cent. When you are looking at risk, if you’ve got strong working capital and you’re only putting 10 to 15 per cent of your wealth out there to grow a crop, you could probably stand most things that might get thrown at you. On the other hand, if you are putting 135 per cent of your net worth out there to grow a crop, that’s not sustainable.”
A farm also needs to factor in how much debt it is trying to service. “The first thing when it comes to financial fluency, is to understand all these concepts and decide where you want to be because if you have weak working capital and you go on investing in depreciating assets or expansion, that working capital is going to get weaker every time you do one of those two things,” says Hammerton. “If you’re gambling on the outcome from the next production cycle putting you back to where you were, or to a better place, and that doesn’t always happen, how far are you prepared to dilute your financial strength in order to do those things?”
What is internal strength?
To help insulate a farm business in unpredictable times it needs internal strength, but what does that look like? Business textbooks talk about a four-quadrant model of production, finances, marketing and people. At a certain level, says Hammerton, everything depends on the people to implement the plan, but if a farm wants to be successful for the long-term, it needs to have a sustainable and efficient production model.
“Whatever type of farming you do, you need to do it well,” he says. “For crop production, that all starts with a sustainable rotation that is based on good, sound agronomy.”
That may seem like an obvious statement, but the reality is that numerous forces can cause farms to make short-term crop rotation decisions that aren’t sustainable in the long-term, and that can change the dynamic in terms of its ability to sustain its production and financial health as well.
As an example, says Hammerton, there has been a lot of over-cropping of canola and pulses in many areas of Saskatchewan.
“We don’t particularly like to see any more than 15 per cent of acres into canola in southwest Saskatchewan because it’s a high-cost crop to grow, and if you get blistering heat in July, it fries the flowers and severely diminishes your yield, so from a risk perspective, we like to see a rotation that’s 50 per cent cereals based on a cereal every other year, maybe a quarter of the acres to lentils and then the remaining 25 per cent split between any two of about five crops which could include an additional pulse or maybe an oilseed.”
Farmers that follow this kind of rotation, adds Hammerton, tend to get stronger yields and spend less on weed and disease control.
“So, you can have a virtual circle of lower input costs and higher output,” he says. “Higher output doesn’t always mean higher revenue, but if you’re getting more bushels for lower input costs, that can go a long way to compensate for not growing as many acres of your most profitable crop as you would probably like to, and you can keep on doing it.”
Although there are obviously situations where farmers have fewer options about what they can grow, the bottom line is that the effects of a bad rotation will linger for a long time, says Hammerton, and farmers know their goals can’t be all focused on just that one year and quick profits. “Cheating on the rotation is fantastic until it isn’t, and once it fails, it could be a very long road back because root disease and chronic weed problems don’t just go away,” he adds.
Perhaps because of his plant-science background, Hammerton advises his clients to make use of good, independent agronomy advice and keep themselves educated about the science of crop production.
“One of the other things that has happened in the last decade or so is that farmers have adopted new technology,” Hammerton says. “They farm more aggressively because they’ve been incentivized to do so by having more successful years based on decent prices for the most part, and some good growing seasons, especially prior to 2017. But now, there are a lot of people putting technology ahead of science and the two are not always the same. If you understand the science, you will be a more discerning user of the technology.”
Managing the risk
If businesses took no risks, they most likely would never grow or expand, and farms are no different, but the question to ask is what is the farm prepared to pay to cover that risk and how are they going to do it?
There are options — such as government and private insurance programs that farmers can use to help cover some of their risk, but they should be aware of exactly how those programs work and what they will actually cover, cautions Hammerton, who runs them through MNP’s Agricultural Risk Management Projector to help them figure these things out. Farmers enter their production and financial data, and the projector adjusts from 100 per cent of anticipated yield down to zero yield to see where the various insurance programs kick in and how much coverage they give.
“What we have seen is that as farmers have difficult years, some of the coverage in these programs diminishes because their margins have been eroded as their yields have been depressed by a number of bad years, and because the private programs have lowered their attachment points for revenue and margins in many cases, as compared to three or four years ago, when farmers were getting better results,” says Hammerton. “So, all of a sudden, they’re paying for insurance that isn’t necessarily going to kick in where they think it will, or need it to, particularly if their cost base has increased. If they have a low cost base, and a history of high revenue, they will get the best coverage and, in some cases, could be bomb-proof, at least in the short term, but they need to understand how these programs work and how the coverage offered can vary over time.”
Businesses can fail not just because they are not profitable, but because they run out of money. “Understanding what it means to overreach yourself is also where financial fluency comes in, together with an appreciation of your own limitations as a manager,” says Hammerton.
“Farmers who understand the management requirements of the business, who get these points about production and finances, and recognize the roles of the supporting cast in trying to drive those twin objectives forward, are the people who do best, whatever the circumstances. They expand when the opportunity is there and continue to be successful when times are tough.”