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by Bob Parsons, UVM Extension
E-mail: bob.parsons@uvm.edu
by Bob Parsons, Assistant Professor of Farm Management, University of
Vermont
This is the third article in a series examining different areas of risk
confronting farmers. This article and earlier ones in the series can be
found on the Vermont Department of Agriculture's Website at www.state.vt.us/agric
Changing Times
The farmer of 30 years ago most likely did his financial management in
his head or on the back of an envelope. Today's farms are too complex
for the operator to manage the finances in his or her head, with considerable
equity and borrowed money at risk if they make mistakes.
Managing the finances requires the farm manager to work closely with a
knowledgeable lender to make sure the farm maintains positive cash flow,
a sound financial base, provides for family living costs, and allows for
future growth. All while assuring the lender and your family that the
farm is in good financial hands. Not an easy task.
The Basics
Let's reduce our discussion of financial risk to three basic areas. One,
managing cash flow to be able to pay bills as they become due. Two, managing
the cost of borrowed money (interest) and its availability (line of credit).
Third, preserving and building owner equity.
The ability of the farmer to work with their lender to handle these components
is essential if the farm is to survive.
The Importance Of Good Records
Well-maintained farm records are an essential tool for sound financial
management.
You don't need a computer or the most complex accounting system or the
most expensive accountant in town. But your records need to be up to date,
convenient, and usable for sound financial management. Records are the
key because they provide you knowledge of the farm's income and expenses,
and are essential for compiling financial statements, ratios, and preparing
tax forms.
Managing Cash Flow
Managing cash flow is essential for the short and long term survival of
any business. The manager has to make sure that there is available cash
to cover operating expenses, make scheduled payments, and provide family
living expenses. Suppliers and lenders like to know they will be paid
in a timely manner. Otherwise, farm credit will dry up, making operating
nearly impossible.
The family depends on the farm to meet living needs. And there is a need
for cash for reinvestment.
Managing cash flow is a tough task on dairy farms but even more difficult
on farms with 'lumpy' income flows, for example fruit/vegetable farms.
To manage cash flows, a budget is an invaluable tool. A budget allows
for planning cash inflow and outflows and provides the manager with an
expectation of cash surpluses and deficits (yes, a cash surplus can occur!).
Budgeting
Budgets do not have to be complicated. First, categorize last year's expenses
and receipts on a monthly basis in one column. Now, project the expenses
and receipts for the coming year using last year as a base.
Ask yourself if milk prices will be lower? Feed prices higher? Will repairs
be lower this year? Don't forget family living expenses. Make the changes
and total each month, carrying the cash balance from the end of the month
as the beginning cash balance for the next.
The budget should be updated monthly as actual receipts and expenses are
recorded. Compare actual to projections and adjust accordingly. Does the
budget indicate the need for some significant 'belt tightening?' When
will a line of credit be needed to cover operating expenses? When will
surplus cash be available for optional business or family needs?
The answers to these questions give the farmer and the lender a picture
for the year and reduces the chance financial 'surprises.'
The Cost of Borrowed Capital
Being aware of the cost of borrowed capital is as important as ever. This
may seem to be a trivial issue with today's historically low interest
rates. But, farmers who can remember back to the early 80's can recall
15-20% rates. With variable interest rates, servicing debt can be (and
was) a cash flow disaster for many farmers.
What can one do to reduce the risk of rising interest rates? Firstly farmers
can try to secure loans that have a fixed interest rate during times of
low rates. This may be difficult with some lenders but a farmer would
be smart to lock in today's low rates for current debts.
A second step is to assure that interest can only be raised no more than
2 points per year. That assures that you won't have big jumps on interest
payments. Also, make sure interest rates are just as flexible downward
as they are upward.
A third item that is essential to managing the cost of borrowed money
is the wise use of a line of credit.
The wise use of credit can assure capturing discounts and making it through
periods when large production expenses come due. For example, use a line
of credit to capture early payment discounts on feed, seed, fertilizer,
or chemicals. As long as the discount is greater than the cost of borrowed
credit, the farmer has made a wise financial choice that can yield greater
profitability.
However, credit lines cause unplanned interest expenses if efforts are
not made to repay them as soon as possible. All too often lines of credit
are maxed because repayment is too flexible. Credit lines then require
refinancing with longer term loans.
The key to the wise use of a line of credit is to use it sparingly, make
sure it is used for short term purchases, and that there is a plan to
repay the loan before the end of the production year.
Preserving & Building Owner Equity
Farmers are constantly putting their equity and their future at risk with
financial decisions. Owner's equity is used as collateral to assure lenders
of loan repayment. Operating losses sometimes have to be covered with
savings or sale of assets. So it is essential that farmers realize the
risk of losing hard earned equity from taking on additional debt.
One key aspect of taking on any debt is to assure it will generate cash
and profits to repay the loan. Make sure you are borrowing money to invest
in items that will provide the greatest return. But lets face it, many
farm loans don't necessarily 'pay' for themselves. For instance, an equipment
loan seldom generates a cash flow but the farmer should carefully assess
all alternatives and choose the most cost effective option.
With debt comes the 'capitalization loss' that occurs with any investment.
This is the depreciation that occurs with any purchase and is the biggest
robber of farmer equity. Drive a new tractor off the dealer's lot and
you instantly lose 20%. The same is true of other capital investments.
For example, if you decide to build a new barn, you may add $500,000 of
new debt. But the new barn is not worth $500,000. It may be worth only
$300,000 the day it's completed. The farm has effectively lost $200,000
in equity from the new barn. This amount should be 'repaid' over the life
of the asset. If not, the farmer has lost $200,000 in equity as a result
of deciding to build the new barn and is putting his financial future
at risk.
Protecting equity is difficult as farmers face periods of low prices.
How much should a farmer borrow against their equity to keep operating?
This can only be answered for each individual according to the ability
of the family and their lender to work through the current period. But
each farmer should recall the famous 'First Law of Holes - when in a hole,
stop digging.'
Financial risk is involved with every farm decision. Managing cash flow
to pay bills, family living expenses, and build owner equity requires
a top manager. Realize your farm's needs and work with your lender to
assure you are on sound financial footing.
Remember, financial planning maybe just a plan but it provides you, your
spouse, and your lender the knowledge needed to move the farm in the right
direction.
Click here for a list of local companies
that offer federally supported crop insurance policies.
For more information on risk management and crop insurance you can contact
Louise Waterman at the Vermont Department of Agriculture at (802) 828-6900
or e-mail waterman@agr.state.vt.us
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