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Assessing Your Farm's Risk-Bearing Capacity: The Foundation of Effective Risk Management

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Title: Assessing Your Farm's Risk-Bearing Capacity: The Foundation of Effective Risk Management


1
Assessing Your Farms Risk-Bearing Capacity The
Foundation of Effective Risk Management
Gayle Willett Pacific Northwest Risk Management
Education Project College of Agriculture and Home
Economics Cooperative Extension Department of
Agricultural Economics Washington State University
2
Introduction
Agricultural Production is a High Risk Business
and its Getting Riskier.
1. Nature (time, weather, disease, pests,
etc.) 2. More volatile weather patterns 3. Highly
competitive (price takers, not price
setters) 4. Globalization of markets
3
  • 5. 1996 Farm Act
  • Producer Reactions
  • Enthusiastic about greater flexibility
  • More flexibility in crop selection.
  • Recognition of shift in selected risk management
    responsibilities from federal government to
    individual producers.
  • Transition payments do not vary with market
    prices.
  • Lower price supports.
  • More restrictive disaster payments.

4
  • More Risk..So What?

1. Defined
Volatility of future financial performance.
Possibility of suffering financial harm
  • Chance of economic loss.
  • Chance of failing to cover cash obligations.
  • Chance of bankruptcy.

5
2. Risk is Not a Dirty Four-Letter Word!
In our economic system
Land earns rent, Labor earns wages, Management
earns a salary, Capital earns interest, and
ASSUMING RISK EARNS PROFIT! Without risk in
agriculture there would be no chance of profit.
6
3. More Risk The Good, Bad, and Ugly
GOOD More flexibility and more opportunity to
increase profit. BAD Most of us are risk
averters. More risk adds stress. Risk
management involves time, effort, and dollars.
7
UGLY Some will assume its business as
usual. Will not prepare to deal with added
risk. Difficulty competing in 21st century.
8
  • Objectives of Discussion

1. Outline Four Basic Tasks of Effective Risk
Management. 2. Demonstrate How to Determine Risk
Bearing Capacity Through Use of
  • Financial Statements
  • Financial Analysis
  • Enterprise Budget
  • Whole Farm Cash Flow Budget (primary focus of
    material)

9
3. Identify Sources of Farm Risk 4. Note Risk
Management Tools and Strategies. 5. Use Case Farm
to Illustrate Concepts.
10
BASIC RISK MANAGEMENT TASKS
  • Returns to Effective Risk Management Should
    Increase in Years Ahead
  • Effective Risk Management Involves Four Basic
    Tasks

1. Analyzing Your Farms Risk Bearing
Capacity. 2. Identifying and Prioritizing Your
Sources of Risk.
11
3. Familiarizing Yourself with Risk Management
Tools and Strategies. 4. Selecting and
Implementing a Risk Management Plan.
Tasks can be Represented by a Triangle.
  • Each task is equally important.
  • Ineffectiveness in a particular task causes
    triangle to collapse.

12
RISK MANAGEMENT FRAMEWORK
Sources of Risk
Risk Management Tools
Risk Management Plan
Farms Risk Bearing Capacity
13
ANALYZING YOUR FARMS RISK BEARING CAPACITY
Implies understanding the impact of adversity on
the farms
  • Liquidity
  • Solvency
  • Profitability
  • Repayment capacity
  • Financial efficiency

14
ANALYZING YOUR FARMS RISK BEARING CAPACITY
15
Questions
  • 1. Which of these two farms has the greatest risk
    bearing capacity?
  • 2. Consider the impact of a 10 drop in gross
    receipts due to lower yields and/or prices
  • Lyles cash margin is gone.
  • Elmer enjoys a 75,000 cash margin.

16
  • 3. What happens if gross receipts drop by 36?
    (Close to actual decrease in wheat prices during
    1996-97 and 1997-98).
  • Lyle has a 65,000 cash deficit and must
    sacrifice 27 of net worth.
  • Elmer still has a 10,000 surplus.
  • 4. Who has the weakest risk bearing capacity and
    should be more concerned about risk management?

17
  • Analysis Tools Include
  • Financial Records
  • Financial Statements
  • Balance Sheet
  • Income Statement
  • Statement of Owner Equity
  • Statement of Cash Flows

18
  • Financial Analysis
  • Liquidity
  • Solvency
  • Profitability
  • Repayment Capacity
  • Financial Efficiency
  • Enterprise Budget
  • Whole Farm Cash Flow Projection

19
Meet Profit Farms
  • 1,500-acre dryland grain operation.
  • Operated by Max and Marlene Profit.
  • Sole proprietorship, calendar year, cash tax
    reporting.
  • 1,200 acres owned and 300 acres leased on a
    1/3-landowner, 2/3-operator agreement.
  • Rotation is summer fallow - winter wheat - spring
    barley.
  • Winter wheat yields have ranged between 37 and 82
    bushels per acre over the past 10 years and
    averaged 62 bushels.
  • Barley yields have varied between .75 and 2.1
    tons per acre, and averaged 1.25 tons over the
    past 10 years.

20
  • Financial statements and analysis include
  • Balance sheet for 12/31/X1
  • Balance sheet and supporting schedules for
    12/31/X2
  • Income statement and supporting schedules for X2
  • Statement of owner equity for X2
  • Statement of cash flows for X2
  • Financial analysis summary for X2
  • Projected wheat and barley enterprise budgets
  • Whole farm cash flow projection for X3

21
Using Financial Statements to Look Back
  • Balance Sheet
  • The Starting Point in Determining Risk Bearing
    Capacity
  • Shows assets, liabilities, and net worth on a
    particular date (financial Snapshot).
  • Should be prepared at least one time annually at
    end of accounting period.
  • Format (Farm Financial Standards Council
    Recommendations).

22
Balance Sheet Profit Farms 12/31/X1
23
Format Key Points
  • Combined business and personal
  • Prepared on last day of accounting period,
    12/31/X1.
  • Assets and liability listed in order of
    decreasing liquidity.
  • Current vs. non-current assets and liabilities.
  • Cost and market columns.

24
Reasons for Including Both Cost and Market Values
on Your Balance Sheet
  • To determine if NW changes are due to inflation
    (deflation) and/or retained earnings.
  • To estimate deferred taxes (hidden liability).
  • Market values needed to determine current
    financial position.
  • Selected cost values needed to prepare
    accrual-adjusted income statement.

25
Balance Sheet Max and Marlene Project 12/31/X2
ASSETS
26
Balance Sheet (contd)
ASSETS, (cont.)
27
Balance Sheet (contd)
Assets, cont.
28
LIABILITIES
29
LIABILITIES, (cont.)
30
LIABILITIES, (cont.)
31
LIABILITIES, (cont.)
32
BALANCE SHEET SUPPLEMENTARY SCHEDULESMax and
Marlene Profit12/31/X2
33
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34
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35
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36
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37
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38
Owner Equity Calculations Retained Earnings
Know TA TL NW or NW TA - TL So, Cost
Basis NW 888,778 TA - 340,262 TL
548,516 All retained earnings (dont know
contributed capital)
39
Owner Equity Calculations Valuation Equity
Market
NW 1,332,867 TA - 407,883 TL 924,984
Total Equity 548,516 Retained earnings
60,565 Personal net worth 315,903 Valuation
equity
40
Valuation equity may also be computed as follows
1,264,103 Total business assets, market
888,778 Total business assets, cost 59,422
Deferred tax on non-current assets 315,903
Valuation equity
41
Interpretation of Balance Sheet
42
Balance sheet reflects outcome of all previous
decisions and transactions
Example Sell 10,000 wheat, pay 2,000 current
debt and put 8,000 in checking account. Impact
on balance sheet?
43
Liabilities
Assets
Current 10,000 ? Wheat 8,000 ?
Checking 2,000 ? Current
Current 2,000 ? Accnt. Pay. 2,000 ?
Current
NW A L ? NW ? A ? L ? NW 2,000
2,000 0
44
Financial Statements (cont.)
  • Income Statement
  • Shows net income for the accounting period.
  • Revenues
  • Expenses
  • Net Income
  • Simple in design but difficult in practice.
  • What constitutes revenues?
  • What constitutes expenses?
  • Net measured on a cost or accrual basis?

45
  • Cash Versus Accrual Income Statement
  • Cash
  • Revenues are recognized only when cash is
    received.
  • Expenses are recognized only when payments are
    made for inputs.
  • Accrual
  • Revenues are recognized when commodities or
    services are produced (e.g. when grain is
    harvested).
  • Expenses are recognized when inputs are usednot
    when they are paid for.
  • Insures matching of revenues and expenses during
    accounting period.

46
Cash Basis Income Statement can be Misleading
  • Cash approach can
  • Understate net income when
  • Producing commodities not yet sold for cash.
  • Paying for inputs used in a different accounting
    period.
  • Overstate net income when
  • Receiving cash for commodities not produced in
    current accounting period.
  • Using inputs paid for in a different accounting
    period.

47
THE ACCRUAL PROCESS
48
INCOME STATEMENT Max and Marlene Profit Year
Ending 12/31/X2
49
Income Statement (cont.)
50
Income Statement, (cont.)
51
Income Statement (cont.)
52
Income Statement Supplementary Schedules Max and
Marlene Profit Year Ending 12/31/X2
53
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54
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55
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56
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57
NET FARM INCOME Max and Marlene Profit Year
Ending 12/31/X2 (Cash Basis)
58
Accrual Adjustments Made Easy! Effects of Changes
in Balance Sheet on Income Statement
Balance Sheet Change 1. Increase Assets
Good 2. Increase Liabilities
Bad
Income Statement Change Increase Revenues or
Decrease Expenses Good Increase
Expenses or Decrease Revenues Bad
59
EXERCISE
Accrual Adjustments Impact of Balance Sheet
Changes on Income Statement
60
EXERCISE, (cont.)
61
FINANCIAL STATEMENTS, (cont.)
  • Statement of Owner Equity
  • A crucial link between the balance sheet and the
    income statement.
  • Serves as a final check on accuracy of numbers
    reported.
  • Identifies sources of change in owner equity.

62
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63
Sources of Change in Owner Equity
  • Due to retained income
  • ( NI WD)
  • Due to contributed capital
  • Due to personal net worth
  • Due to valuation equity

64
STATEMENT OF OWNER EQUITY Year Ending
12/31/XX (An Overview)
65
STATEMENT OF OWNER EQUITY Max and Marlene
Profit Year Ending 12/31/X2
66
OWNER EQUITY, (cont.)
67
STATEMENT OF OWNER EQUITY
  • ProfitsSummary
  • Good
  • Statements reconciled
  • Personal net worth improved
  • Valuation equity increased
  • Bad
  • Retained earnings were negative
  • Cost and market net worth decreased

68
RESIDUAL APPROACH TO DETERMINING WITHDRAWALS
Example (Profits) Beginning net worth (cost
basis) Net income Capital contributions/-capita
l distributions Ending net worth (cost basis)
Residual withdrawals
557,074 36,038 0 -548,516 44,596
  • Caution
  • Any errors in accounting are captured as a
    withdrawal amount
  • Residual withdrawal is merely an estimate

69
EXERCISE
Relationship Between Bg NW, NI, WD, and End NW
Assuming Cost Basis Balance Sheets and No Capital
Contributions/Distributions.
70
FINANCIAL STATEMENTS, (cont.)
  • Statement of Cash flows
  • Summarizes cash flows over the accounting period
    by three areas
  • 1. Operating Activities
  • 2. Investing Activities
  • 3. Financing Activities
  • Reconciles change in cash position during
    accounting period.

71
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72
STATEMENT OF CASH FLOWS Max and Marlene
Profit Year Ending 12/31/X2
73
STATEMENT OF CASH FLOWS, (cont.)
74
STATEMENT OF CASH FLOWS, (cont.)
75
STATEMENT OF CASH FLOWS, (cont.)
76
SCF Summary Max and Marlene Profit
  • A major improvement in liquidity (37,157).
  • Sufficient cash from operating activities to
    cover personal withdrawals.
  • Sufficient cash from operating activities
    (56,724) to cover principal on term debt
    (24,027).
  • Disinvested (rather than invested) in depreciable
    capital assets (mach.) (3,500).

77
FINANCIAL ANALYSIS
Analysis of Risk Bearing Capacity/Financial
Strength Should Focus on 5 Areas and Top 10
Measures.
  • Liquidity
  • 1. Working capital
  • 2. Current ratio
  • Solvency
  • 3. Net worth
  • 4. Debt/asset ratio
  • Profitability
  • 5. Net farm income
  • 6. Return on assets
  • 7. Return on equity

78
  • Repayment Capacity
  • 8. Term debt coverage ratio
  • 9. Capital replacement and term debt repayment
    margin
  • Financial Efficiency
  • 10. Operating expense ratio

79
Analysis is Enhanced with Several Comparisons
  • Business performance relative to industry
    guidelines (or producer goals).
  • Current business performance relative to past
    business performance (trend analysis).
  • Current business performance relative to budgeted
    business performance.

80
What Is Your Farms Liquidity Position?
Ability of farm to meet cash obligations as they
come due without disrupting the business. Focus
is on short run.
Liquidity
Measures of Liquidity 1. Working Capital
Current Assets Current Liabilities Profit
Farms 140,603 116,896 23,707
81
Measures of Liquidity,( cont.)
2. Current Ratio Current Assets ? Current
Liabilities
Profit Farms
1.201
82
What Is Your Farms Solvency Position?
Measures of Solvency
3. Net Worth Total Assets - Total Liabilities
Profit Farms (Market) 1,332,867 -
407,883 924,984
83
Measures of Solvency, (cont.)
4. Debt-to-Asset Ratio Total Farm Liabilities ?
Total Farm Assets
Profit Farms (Market) 0.321 (or 32)
Industry Standards Under 30 Green 30 -
70 Yellow Over 70 Red
84
What Is Your Farms Profitability Performance?
Measures of Profitability
Profit Farms 28,211 (see Income Statement)
85
Measures of Profitability, (cont.)
6. Rate of Return on Total Farm Assets
Example
1.3
Industry Standards Over 5 Green 0 -
5 Yellow Under 0 Red
86
Measures of Profitability, (cont.)
7. Rate of Return on Farm Equity
Profit Farms
1.1
Industry Standards Over 15 Green 5 -
15 Yellow Under 5 Red
87
What Is Your Farms Ability to Repay Term Debt?
8. Term Debt Coverage Ratio () Profit Farms
?
88
Industry Standard for Term Debt Coverage
Over 150 Green 110-150 Yellow Less than 110 Red
89
9. Capital Replacement and Term Debt Repayment
Margin
90
How Much Can Revenues Drop Before Term Debt
Repayment Margin is Gone?
1.7
91
How Much Can Expenses Increase Before Term Debt
Repayment Margin is Gone?
92
What Is Your Farms Financial Efficiency?
93
TREND ANALYSIS Max and Marlene Profit Year Ending
12/31/X2 (Market Value)
94
TREND ANALYSIS, (cont.)
95
SUMMARY RISK BEARING CAPACITY ANALYSIS Profit
Farms
  • Liquidity (cash flow) is weak (yellow)
  • Solvency, OK (yellow)
  • Repayment capacity is very weak (red)
  • Cost control is strong (green)
  • Basic problem is depressed profitability
    (yellow/red).
  • If doesnt improve, will soon lead to difficult
    cash flow problems.
  • Risk bearing capacity is weak due to low
    profitability, vulnerable cash flow, and
    considerable debt.

Effective risk management is very important to
Profit Farms.
96
ANALYZING YOUR FARM RISK BEARING CAPACITY -
LOOKING AHEAD
  • Develop Projected Enterprise Budgets
  • Estimate enterprise costs and yields.
  • Understand implications of various pricing
    opportunities relative to cost recovery,
    earnings, and cash flow.
  • Contributes to more informed, focused, and
    disciplined marketing and risk taking.
  • See What Is Your Cost of Production? for more
    detail.

97
  • Develop Projected Whole Farm Cash Flow Budget

98
  • Develop Whole Farm Cash Flow Budget, (cont.)
  • Determine commodity yields and prices required to
    cover whole farm cash obligations.
  • Analyze vulnerability of cash flow to downside
    risks
  • Lower yields
  • Lower commodity prices
  • Higher costs/expenditures
  • Contributes to more informed, focused, and
    disciplined marketing and risk taking.
  • See What Is Your Cost of Production? for more
    details.

99
RISK MANAGEMENT FRAMEWORK
Risk Management Tools
Sources of Risk
Farms Risk Bearing Capacity
100
ANALYZING YOUR FARMS SOURCES OF RISK
  • Leading Candidates
  • 1. Production
  • Variability in commodity yield and quality.
  • 2. Market and Price
  • Variability in commodity and input prices.
  • 3. Financial
  • Variability in returns to equity and in cash
    flow due to financing arrangements.
  • 4. Technology
  • Risk of adopting new technology too late or too
    early.

101
ANALYZING YOUR FARMS SOURCES OF RISK
  • Leading Candidates, cont.
  • 5. Casualty Loss Risk
  • Risk of losing assets due to fire, wind, theft,
    flood, vandalism, etc.
  • 6. Social and Legal
  • Risk associated with changes in government
    programs, tax laws, environmental agenda,
    property rights, etc.
  • 7. Human
  • Changes in availability of labor and management.

102
  • Important to prioritize these sources of risk.
  • Vary from farm to farm and over time.
  • Provide direction in selecting sound risk
    management strategies.

103
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104
RISK MANAGEMENT TOOLS AND STRATEGIES
  • 1. Production Risks
  • Choose enterprises with more stable yields
    (quantity and quality)
  • Crop insurance (fire and hail, multi- peril,
    revenue)
  • Enterprise diversification
  • Geographical diversification
  • Drought/disease/pest resistant varieties/rotations
  • Pesticides
  • Excess machine capacity
  • Keep resource reserves

105
  • 2. Market Risks
  • Averaging sales
  • Cash forward contract (commodities and inputs)
  • Hedging on the futures market
  • Options on futures
  • CCC loan
  • Enterprise diversification
  • Crop revenue insurance
  • Choose enterprises with low risk of changing
    commodity prices
  • Review outlook information
  • Hire professional help

106
  • 3. Financial Risks
  • Less debt/leverage
  • Higher credit reserves
  • Higher liquid reserves
  • Fixed interest rates on term loans
  • Longer term loan repayment periods
  • Substitute crop-share or variable cash rent for
    fixed cash rent
  • Longer term leases

107
4. Technology Risks
  • Keep informed about new developments
  • Periodically analyze the economics of new
    technology
  • Rent machinery

5. Casualty Loss Risks
  • Use property insurance

108
6. Social and Legal Risks
  • Keep informed
  • Develop long-range plans and re-evaluate
    frequently
  • Participate in public policy making
  • Liability insurance

109
7. Human Risks
  • Health/disability insurance
  • Life insurance
  • Backup management
  • Improve family and business communications
  • Estate planning

110
SELECT AND IMPLEMENT RISK MANAGEMENT PLAN
  • Final Task in Risk Management Process
  • Producers Who
  • Understand risk bearing capacity of business
  • Have identified and prioritized sources, of
    risk and
  • Have analyzed the costs and benefits of various
    risk management tools and strategies for
    controlling major threats are in a

Good Position to Implement an Appropriate Risk
Management Plan!
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