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Friday, November 18, 2011

Financially Protect Your Farm From Lower Margins And Higher Capital Costs


From the day that you bought your first bag of seed and buried it an inch or so in the ground you had to admit that your psyche was fed with risk.  But you also were ready to reap the rewards if the risk paid off, and it did for most people, most years.  However, the ones who took too much risk may not be farming today.  And the ones who did not take enough risk may not be farming either.  The management of risk and knowing what you can handle will be the key to determining whether you are farming next year.

Operational risk and financial risk are the two primary types in agriculture, although there are others.  The operational type is a function of production and price.  And the financial risk is a function of the debt you have undertaken and the interest you are paying.  Your key to success is managing those and knowing when to take evasive action that will allow you to discard some of your risk at a time when there will be insufficient reward, no matter how well it is managed.  Purdue economists Mike Boehlje and Brent Gloy report that production risk has grown wildly aggressive in recent years and financial risk has become meek and mild.  So how can you manage for profitability?  Their recent newsletter provides nine steps to successfully capturing profitable opportunities in the current economic environment.

Regarding operational risk the Purdue economists say price volatility has become double what it was 5-10 years ago, with yield variability becoming a perennial challenge.  Additionally, input prices have exhibited great variability, with resulting profit becoming highly variable as well, as much as 3-4 fold compared to the past.  They report that budgeted margins for the 15 years after 1990 were within $50 per acre of either being profit or loss, but for the past 6 years, budgeted margins have been within $150 to $250 per acre for five of the six years.

The economists say financial risk increases when debt financing is used, and since it must be repaid, there is another risk that operating receipts will be insufficient to pay the debt service and retire the debt.  However they report that the recent combination of reduced debt used by farms and the historically low interest rates has resulted in much lower financial risk for most farming operations.  They caution against assuming that interest will remain low because when they increase, the cost of financial risk may be come unbearably large if there is a high amount of debt.

Boehlje and Gloy rhetorically ask if farmers have been rewarded for the increased amount of risk by the potential for higher returns in farming.  They conclude the answer is positive for an average of the past 8-10 years compared to the prior decade.  However they say those favorable margins have been more volatile than anytime previously, and are far from stable. 

Subsequently, they offer some strategic measures that can be implemented to capture the higher returns now available.
1) Lock in margins with the use of futures markets or jointly contracting both output and input prices.
2) Buy crop insurance to manage the risk of yield, while price risk is being managed in the first strategy.  They suggest that because of higher input costs, one should consider higher levels of coverage and it also provides a higher comfort level to lock in margins for that protected yield.
3) Fix long term interest rates to take advantage of current low rates.  While today‚Äôs long term rates are higher than the short term rates, the overall magnitude of the rates is still quite low.
4) Pay down debt with the use of high margins from crop returns and eliminate debt that will always have to be serviced.  Farming operations that have grown aggressively in recent years with debt financing should deleverage over the next few years, and avoid the risk of having to pay high interest rates with low crop margins in future years.
5) Establish a financial reserve that will provide a cushion in times of financial stress.  This may be in the form of more working capital, higher cash positions or reduced debt obligations, all of which can protect against low margins and high interest rates in the future.
6) Caution against aggressively bidding either for farmland purchases or on high levels of cash rent.  With expectations for lower margins in the future, compared to the historically high levels of today, overbidding will not become a burden.
7) Grow at a slower rate than in the past, or finance the growth with equity instead of debt.  Higher capital costs in the future will impose more limits on growth.
8) Invest in strategies that lower the cost of production and eliminate operational costs that are unnecessarily high.
9) Make prudent capital investments that increase efficiency and lower costs.  With a strong cash position on many grain farms, it may be a time to conserve that cash instead of spending it.

Margins are volatile, but at a historically high level.  Many practical strategies can be employed to capture high returns by locking in both input and outputs, and with the use of crop insurance.  Additionally, judicious use of debt and equity will protect from lower margins and higher financial costs in the future.

Posted by Stu Ellis on 11/18 at 01:10 AM | Permalink

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