4 financial tools to keep you afloat

Agriculture is a cyclical business. We will have another upswing.

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Published on September 24, 2020

The present downturn in net farm income may be particularly severe and unusually long in duration, but it could be helpful to remember that it is indeed part of the up-and-down cycle inherent in farming. In time, this low will give way to another high.

"What we've learned from history is that agriculture is a cyclical business; we will have another upswing," says Kevin Bernhardt, agricultural professor at University of Wisconsin-Platteville and farm management specialist with the Center for Dairy Profitability and the University of Wisconsin Extension.

Staying afloat while riding the low waves in farm income may be a difficult balancing act, but it has its rewards when the cycle peaks. How you ride out this present low and its subsequent high affects the farm's survival of the next low and its ability to take advantage of future opportunities.

"When the storm clouds pass and margins are more favorable, the sustainably profitable operations will get back to work preparing their operation to be resilient for the next downturn," says Bernhardt. "There are many more options when margins are good to protect the farm business for the next downturn."

Many of the management tactics needed to ride out the bottom of the income cycle are the same ones that can rebuild economic resilience into the operation during high tide, he says. Long-term resilience for riding both low and high tides comes from doing a lot of little things well. The benefits add up.

"It's common for farmers to look for a silver bullet solution to financial problems," says Bernhardt. "But it's hard to find just one thing that will help. Those who do well are 5% farmers. They're doing every little thing – just 5% better than the average. They keep a close eye on cost of production; they have a good understanding of how much to put into maximizing profit, not yield. They adjust these inputs according to whether we are in the high or low part of the cycle."

Bernhardt points to his experience with Wisconsin's dairy farmers, hard hit by prolonged depression in milk prices. Business records show that within every herd-size grouping, there are producers who find ways to stay profitable.

Such financial resilience comes, in part, from analyzing business records. The analyses can point the way to needed changes that may reduce losses or even increase profit.

"A diagnostic system is needed that can process the many bits of financial data into a coherent means to track and diagnose where bottlenecks may lie and ultimately where management time should be spent," says Bernhardt. "A lot of different tools are available to help you analyze what's happening in your operation. They can help you find the red flags."

4 Suggested Financial Tools

1. Financial analysis

"The Farm Finance Scorecard and the DuPont System for Financial Analysis are diagnostic tools that can help you assess the status of profitability and determine areas of deficiency and/or opportunity," he says. "These tools can help you measure the strength of debt structure, repayment capacity, asset utilization, and efficiency."

Using either tool requires complete accrual adjusted income statements and balance sheets.

The Farm Finance Scorecard evaluates financial ratios in a benchmarking system that interprets the strength or vulnerability of the ratio. A weak ratio suggests a need to change management practices.

Asset turnover ratio, for instance, results from gross revenue divided by total assets. The result indicates how well assets are being used to create gross revenue. If the ratio suggests assets are being underused in a dairy operation, for example, the producer might work to reduce mortality rates, improve conception rates, improve feed conversion, or cull unprofitable cows.

Another financial diagnostic tool is the DuPont System for Financial Analysis. "This system uses many of the same ratios as the Farm Finance Scorecard," says Bernhardt. "It evaluates three primary levers of profitability: asset use to create gross revenues, efficiency of management in converting gross revenues into net revenues, and the use of debt financing to multiply the profit-earning capability of one's own equity."

2. Budget planning

"Budgeting is a process of looking forward," says Bernhardt. "Budget planning is a tool that lets you plan for what you think will happen or that you want to happen. Budgeting tools include enterprise, whole farm, partial, and cash flow budgets. Cash flow budgets are particularly important in periods of tight margins. The cash flow budget plans for incoming cash, outgoing cash, and borrowing needs."

Budgeting for the cost of fertilizer, seed, and fuel, for instance, gives an idea of cost of production, of course. Budget planning in advance of spending the money gives flexibility. If the budget doesn't look good, you can try to find ways to reduce costs.

3. Variance analysis

After costs and income projected in the budget become reality, tracking how the actual numbers stack up against projections can help you spot any red flags.

"The power in the budgeting process is tracking it throughout the year and determining the difference between plans and actuals," says Bernhardt. "If done monthly, for example, corrective actions can be made, including communicating with your lender well in advance of potential shortfalls. Or, by finding the shortfall early, maybe there is something you can do now to correct it."

4. Partial budgets

Creating a partial budget lets you evaluate the possible costs and income resulting from potential management changes. Partial budgets can evaluate such changes as new rations, altered cow groupings, or different tillage systems.

A partial budget evaluates new revenues that might be generated by the change. It estimates the current costs that might be reduced or eliminated by the change, what increased costs might result, and what current revenue could be lost as a result of the change.

Riding the low tide in net farm income with care gives you a shot at shoring up your operation during the coming high tide of the cycle.

"During the coming upswing, you can pay off debt, replace machinery, and rebuild working capital," says Bernhardt. "Prepare then to take advantage of the opportunities that may come with the next bottoming out of the cycle. The best time to buy cattle, machinery, and land is often during the down cycle."