Financial Risk Management
Sound planning and financial control are the keys to managing financial risk. The Risk Management Agency (RMA) identifies financial risk as three basic components for the agricultural business. They include:
  1. Cost and availability of debt capital,
  2. Ability to meet cash-flow needs in a timely manner and,
  3. Ability to maintain and grow equity.

Let’s look at these three components.
  1. The cost and availability of debt capital. Capital is required to run any business. It’s only sources are equity capital and debt capital.
  • The business owner provides the equity capital.
  • Debt capital is sourcing the capital from outside creditors. The outside creditors include a commercial bank, individuals, vendors, trade credit and/or the Farm Credit System.

Securing equity and debt capital is a vital element to the success of an agricultural business. Debt capital increases business risk.

It is important to recognize the different purposes and structure of debt capital.

Operating Debt – This type of debt helps a business manage its cash flow. This debt will provide the necessary capital to a business during the seasonal cash flow valleys when expenses exceed income.

The business manager that recognizes the dollar amount of the valleys and the timing during the year will be able to position their business to utilize operating debt capital effectively.

In order to determine the amount and the timing of operating debt, a cash flow statement is required. This is an important management tool to utilize operating debt to its maximum benefit for the business.

Capital Debt – This type of debt provides the funding for capital investment. Capital investment includes machinery/equipment, leasehold improvements and expansion funding.

The business owner should complete a partial budget for each investment. The partial budget should account for the added revenue/reduced costs and reduced revenue/increased costs associated with the investment. This analysis will determine the return on the investment so the business owner can assess whether the investment returns sufficient funds to the business.

The cost and structure of the debt is a critical element when determining cost of the investment. The business owner should match the loan terms to the life of the asset as determined by economic depreciable life. The business should pay off the loan prior to the equipment becoming a “high repair” cost asset.

Long Term Debt – This type of debt provides the funding for long term investments like real estate. The business owner must secure a least cost loan that meets the return requirements of the investment and meet the profitability and cash flow needs of the business.

It is equally important to develop a good relationship with your primary lender who understands your business plans so that you have access to debt capital when needed. Business growth is impeded when debt is not available at the right times. Too much debt will place a significant burden on the business so debt management is a critical management component. Without proper analysis, structuring and planning, debt capital can lead to complications and risks that could become unmanageable.

The ability to meet cash-flow needs in a timely manner - Cash-flow management is a critical element for all businesses and particularly for agricultural seasonal businesses. There are many months of the year where expenses will exceed income. The business owner should identify funding needs on a month to month basis. This will determine funding needs and timing.

It is important to determine the amount of working capital (current assets minus current liabilities) that will fund the cash flow valleys versus borrowing operating debt. It is critical that an agricultural enterprise have sufficient working capital to help meet the necessary expenses of the business during the lean times of year. One barometer is that working capital should be at least 25% of total annual expenses. This is a very important risk management financial component.

Setting working capital goals is one of the critical key elements for the financial success of a business. Without sufficient working capital the business will not be able to meet its obligations in a timely manner putting the business at risk for failure when adversity strikes. Each agricultural industry has its own requirements for working capital. Understanding your industry’s working capital requirements is paramount to the success of your business.

The ability to maintain and grow equity- This is the ultimate objective of any agricultural enterprise because without maintaining equity the business would become insolvent. Without growing equity the business will not keep ahead of inflation. Eventually this leads to insolvency because inflation will reduce the value of the equity in the business in the long term. There are many management considerations when discussing the ability to grow and maintain equity. A key element is sufficient sustainable annual accrual and cash profits.

The required profit level is different for each business. When determining sufficient profitability many factors come into play. For example; family living expense, capital reinvestment requirements, term debt payment requirements, return on investment requirements set by management.

There are many tools available for a business owner to manage growth. They include but are not limited to budgets, proformas, monitoring systems and business plans. All are critical for the long term success of any business and all involve planning.

David Kohl, a professor of agricultural economics at Virginia Tech, in a published study reported that planning is a critical process for the farmer that very few go through formally. However, there are some very real benefits that accrue to those who do;

Those with goals in their heads earn 3 times as much money and attain 3 times as much wealth;

Those with written goals earn 9 times as much money;

Those with formal business plans make 20 times more money.

Plus, good management, which includes planning, is the single most important factor separating profitable and less than profitable businesses today.

The business owners that can employ good financial risk management strategies are the entrepreneurs who will succeed in the competitive agricultural industry.