Evaluating options for change

Damona Doye, Extension Economist, Oklahoma State University

Often, it is only when circumstances force us to re-examine our daily routines and plans that we do so. High feed and grain prices fueled by growth in demand for biofuels, for instance, are causing many producers to rethink farm plans either to take advantage of high prices as a crop producer or to seek lower-cost feed inputs as a livestock producer. Within an industry, periods of high profitability often do not provide an incentive to change. But, “good” times may be the best time for a business audit and fine-tuning. When businesses are in financial trouble, the options available for change are often very limited.

With changing economic circumstances, the risk environment changes, as does the operator's ability to tolerate risk, both personally and financially. New constraints or limits on borrowing imposed by a lender may arise. Goals that may have seemed reasonable may no longer seem appropriate or may conflict with each other. Once goals and priorities have been re-assessed, the operator is prepared to develop a revised plan for the future.

The ability to change depends on the business' financial position, its historical performance and its stage in the business life cycle (start-up, growing or mature) as well as the financial demands placed on the farm by the family. The discussion that follows is intended to be a guide in beginning an internal audit of the farm business.

Crop failures, low commodity prices and other changes in the economic environment contribute to financial difficulties for farms. What can a farmer or rancher do to improve the business' financial position when the need for change is recognized? Careful management, changes in the farm enterprise mix, changes in asset ownership, supplementing income with custom or off-farm work, debt restructuring, adjusting farm and family living expenditures and liquidating part or all of the farm assets are alternatives.

Giving up equity or increasing debt to cover a cash flow problem is generally not a cure. Often, a larger problem must be solved. Changes must be evaluated with respect to the source of financial difficulties. This [article] discusses options for change and points out factors to consider in the decision-making process.

Identifying the problem
Farm financial problems may be ongoing, recurring or only occasional. They may result from cash flow difficulties, lack of profitability, low business equity or a combination of these. To help determine the primary culprit, ask these questions:

1. Are bills and debts paid as they come due?

2. Could they be paid given an extended repayment period?

3. Does the farming operation generate income for family living or does the farm consistently lose money?

4. Could the money tied up in the farm business earn more in an alternative investment?

5. Are savings sufficient to weather one or two years of severe crop or livestock losses?

6. Could money be borrowed to cover cash shortfalls in the event of a business or family emergency?

The first two questions relate to farm liquidity. The inability to make payments as they come due is a sign of cash flow problems. Questions three and four probe farm profitability. The inability of the farm to generate adequate income or returns on assets can indicate long-term, profit-based problems. If the answer to questions five and six are “no”, then low equity or solvency may be a concern.

Considerations
Farm profitability can be improved by implementing changes that increase volume or price per unit or lower cost per unit of production. Farm net worth or equity can be increased over time by increasing profits, carefully managing debt loads, limiting withdrawals and managing income taxes. Fixed asset (for example, land, machinery and equipment) utilization and management are also critical to success for the decision-maker.

Many factors must be considered in any proposed decision to significantly change the structure or operation of the farm business. First, the change should be evaluated with respect to farm and family goals. For example, adding a dairy enterprise makes little sense for the family who values being able to take a two-week family vacation each year (unless substitute labor is readily available).

In addition to the impacts on labor and management, financial repercussions should be anticipated, including impacts on liquidity, solvency and profitability. How will the change affect the business' ability to pay bills in a timely fashion? Will additional borrowing be needed to finance the change? Will the change generate positive net returns in the long run? The human and capital resources available and the economic climate (regulations and governmental policies, for instance) may limit the alternatives. Intangibles such as desired family involvement and reliability of existing and proposed new business partners should be considered.

Evaluating changes should include long-range budgeting, with estimating total receipts, total costs and net earnings for each alternative estimated to identify the best chance of achieving satisfactory levels of profitability, liquidity and solvency. In developing the budget, list all ownership and operating costs and consider intangibles like reliability, timeliness and pride.

Ownership costs include depreciation, interest on investment, insurance, property taxes and housing or storage costs on capital assets such as machinery and equipment. Operating costs include fuel and lubrication, repairs, labor, feed, seed and annual operating capital. If credit is needed to finance the change, consider the farm's debt repayment capacity.

Determining which alternatives to analyze depends on the business' problems, the kind and amount of resources available and the economic climate. If a major change is planned, cash flow planning is essential to find out whether the business can survive a transition from one alternative plan to another and to clarify risks involved. Follow up long-range planning and budgeting with short-range cash flow planning.

In the budgeting and evaluation process, keep in mind that relative risk assessment is also critical. Switching to an enterprise in which no family members have previous production, marketing or management experience is risky. Will a lender go along with the change, or can financing be obtained if needed to make the change? Also, be sure to consider timing aspects of the farm or ranch's alternative plan. If new skills are required, is there sufficient time to learn them? If change is needed quickly, is there time to make any needed investments associate with the change and implement a new farm plan? If a new enterprise is added, will it require labor at peak or off-peak seasons?

Finally, when any substantial change is being considered, consult with a tax professional to ensure that any potential tax ramifications are clear.

Improved management

Farm costs control
While ‘farm costs control' is not an attention-grabbing headline, research consistently shows that controlling costs over time is a key element in long-term business success. Attempting to take an objective view of your farm's finances can be revealing. Lay out three years of tax returns side by side. What are the high-cost categories?

An internal audit may be needed on the farm to determine if resources (land, labor, machinery, equipment, money and management) are being used efficiently, effectively and profitably? Farm records should be studied to ensure that inputs are being purchased as cheaply as possible and are being fully utilized. Look most closely at high-cost items such as interest, machinery costs, rent, feed, fertilizer and labor.

Some costs may be relatively fixed, some may be variable and still others may be negotiable. Once you've bought land or machinery, equipment, vehicles, breeding livestock or similar capital assets, ownership costs are relatively fixed. If fixed costs are not being spread over adequate levels of production, fixed costs can be reduced by expanding the business, doing custom work for others or selling assets.

To lower variable costs, consider substituting comparable but less expensive inputs; for instance, adjusting feed rations to utilize relatively low price grains. Shop around for the best prices on all big ticket items. Assess whether inputs could be used more efficiently, such as feeding hay in rings to minimize waste. Perhaps machinery costs can be reduced by custom hiring work done or by doing exchange work with other farmers. High repair costs on machinery or equipment may signal the need for additional investment in new equipment or preventative maintenance.

In the long run, rethinking asset ownership plans can lead to lower costs. For instance, custom hiring or leasing may be a good alternative when high-cost, specialized machinery and equipment is used infrequently or for relatively few hours. Be sure hired labor is fully employed, and minimize time being spent on make-work jobs.

If land purchase payments are crippling cash flow, consider leasing rather than owning real estate. If rental rates are out of line with the market, talk to the landlord and see if a new rate can be negotiated. Renegotiating a cash lease to lower the payment will reduce current expenses. Also, changing a cash lease to a share lease will reduce cash outlays and improve liquidity, particularly in poor yield and low price years.

Flexible leases can be used to share production and price risk between the tenant and landowner. Flexible leases can be developed in many forms, including a combination of cash and share leases. In lease agreements for machinery or other equipment, the payment amount, number of payments, timing of payment, principal and interest rates and end date of lease purchase agreements are variables to evaluate.

Schedule loan repayments at times when crop or livestock sales are expected. Negotiate for lower rates if you have a good record keeping system and can provide financial statements for the lender. Check your depreciation schedule on your tax returns to make sure it is up-to-date.

Income levels
Income generated is a function of both farm yields and prices received for production. Thus, improving either production and marketing practices can increase farm returns. Having a deliberate marketing plan, producing at the level at which costs will increase more than returns if the crop or livestock yield increases and utilizing all assets that have income potential are keys to maximizing profits.

In addition to cost control, farm returns may be increased by improving marketing and production techniques and by wisely managing underutilized resources. Learning new production or marketing skills may require an investment in terms of time and money. Join a marketing club to “practice” using new tools, then slowly implement them on the farm. Absolutely do not expect to get rich quick, and do not bet to save the farm through risky trading schemes. Rather, use marketing tools wisely to manage risk.

Another way to increase returns per acre or per head is to increase the yield (or reduce production losses). Are you using the most productive seed variety in your crops? Are you managing livestock so death losses are minimized? Having the highest crop yield or the highest average weaning weight may give you bragging rights at the coffee shop, but it doesn't guarantee a profit. Keep in mind that producing more is not always better. Higher production levels must exceed the additional costs incurred to generate those higher yields.

Identify both resources and assets that may not be fully utilized at present but which have income potential, and identify underutilized assets. If opportunities exist and labor is available, increase asset use through custom farming or renting machinery to other farmers. This helps increase machine utilization, thus lowering the ownership costs that must be paid by your farm, and increases cash income. Crop share leasing may be an option to generate cash income from owned land that has limited value. If operating funds are not available for planting a crop or producing livestock, rent the farm out and use proceeds to pay debt obligations.

Insurance protection
To protect against losses that might cripple or ruin the business, consider insurance. Financially stressed farms often cannot afford a loss which might lead to delinquent loans or more borrowing. Federally subsidized crop insurance (and forage insurance in some areas) is an alternative for many producers. Crop insurance helps minimize the losses associated with adverse events largely outside the producer's control. It presents an opportunity to substitute known costs (annual premiums) with unpredictable and irregular yield losses.

Liability, property and life insurance are also means to help protect farm assets. All insurance policies should be reviewed both from protection and cost standpoints. If your vehicles are aged, you may not need the same level of insurance that you did when they were new. Don't forget to include health care and long term care insurance in your review as they are increasingly important risk management tools on farms.

Change in enterprise mix
A whole farm financial plan, complete with enterprise budgets, is a useful means of identifying farm cost and profit centers. Knowing the relative contributions of different crop and livestock enterprises allows producers to redirect resources (for instance, labor or land) to profitable enterprises and away from less profitable enterprises.

Producers may want to consider a new, promising enterprise if it fits with the rest of the farming operation and farm and family goals. The impact on cash flow depends on changes in the levels of production of existing enterprises, whether capital assets are sold or purchased and the added cash flow demands of any new enterprises. If cutting costs, improving marketing skills, increasing yields or outputs when economically feasible and gaining insurance for potentially devastating losses have not remedied problems, then a change in the whole farm plan may be needed.

Often people investigate alternative enterprises thinking they will provide higher profits with less effort. Wouldn't everyone like to stumble on a get-rich-quick opportunity? What they often find is that new enterprises are more demanding when it comes to management and also require new and different skills. Before adding a new enterprise, think about how it fits in with the rest of the farming operation. Does it complement, supplement or compete with present activities?

A complementary enterprise will not negatively affect the returns to existing enterprises. A supplementary enterprise will generate new income and, at the same time, enhance profits in an existing enterprise and generate income from the new enterprise. A new enterprise which competes with existing enterprises for resources may lower the profitability of the existing enterprise. Are the expected returns to the new enterprise enough to compensate for potential losses?

Change in asset ownership
While producers often feel that they must own land to be farmers or ranchers, some enterprises will not generate the cash necessary to make principal and interest payments, even though potential price appreciation makes ownership seem rational. Real estate (land and buildings) can be controlled by owning, leasing with a multi-year arrangement or renting on an annual or short-term basis. Producers should also evaluate whether machinery and equipment is earning its keep, particularly on small operations. Machinery and equipment can be owned, leased or custom-hired. Breeding stock can also be leased or owned.

Rental markets may be better developed in some areas than others. Renting or leasing an asset reduces the ownership costs (depreciation, taxes, insurance, interest on investment) while increasing the cash flow and possibly the operating capital needed.

Leasing machinery or equipment
Leasing is an alternative to acquire use of other farm assets. Operating leases are usually short-term rental arrangements with rental costs based on use, either number of hours or number of acres. The owner of the machinery or equipment usually pays for repair and maintenance; the farmer is responsible for fuel costs and labor. The cost of the lease to the farmer can be deducted for tax purposes.

Machinery availability may be a risk for the farmer with short-term or seasonal operating leases. A financial lease using a long-term contract may alleviate the problem. The long-term agreement is similar to ownership in providing for the useful life of the machinery or equipment. Because the farmer has exclusive rights to use the asset over its useful life, the long-term agreement is similar to ownership. Under a financial lease, the farmer pays all repair, maintenance and operating costs.

Options at the end of the financial lease can include the right to:

1. purchase the asset for an amount specified when the lease is signed

2. purchase the asset at fair market value

3. renew the lease

4. return the equipment to the owner or lessor

Custom hiring
Another alternative to owning machinery and equipment is to hire work done. With custom hire, ownership costs are avoided. Capital and labor can be channeled to other uses. Specialized operations may benefit from the experience of skilled operators. Jobs may be completed faster using several machines, and machine use can be readily adjusted to changes in crop mix and market conditions. However, service may not be available at the best time, reliability of custom operators may be a concern and rates are variable.

Family issues that impact the farm business

Family withdrawals
Farm families should be sure that their expectations with respect to the farm's ability to generate income are realistic. Family living expenses typically rise as the family expands until the children are self-sufficient. If plans include bringing them back into the operation as adults, additional careful planning must be done.

If financial stress is an issue, curbing family living expenses frees up cash for other uses. Developing a budget, living within it and minimizing nonessential spending may allow producers to pay down high-interest loans and credit card debts, reducing future cash obligations for loan repayment. At the same time, postponing major expenditures or purchases, such as a new vehicle or other similar item, may increase future demands on farm income.

Supplemental income
The number of families who earn income solely from the farm has dramatically decreased over time. Off-farm income helps provide a safety net and diversifies the financial risks families face. Farm income can be supplemented through income from an off-farm job, a home-based business or from custom work done for other farmers. Deciding if anyone, and who, should take an off-farm job may depend on the skills of family members, age and the need for their expertise on-farm. Diverting hours from the farm may result in a labor shortage at critical times, reducing productivity. Job opportunities may be limited in rural areas.

Adjustments in farm or family withdrawals
Often, some flexibility exists in the amount of money reinvested in the farm or used for family living expenses. Financially stressed farmers may delay investments and machinery and equipment purchases. Automobiles can be driven longer and new home furnishings and home improvements delayed. These adjustments may be enough when financial stress is not severe. They buy time for the operator to make other operational changes. However, equipment, machinery and buildings eventually need to be replaced. In some cases, expectations of what the farm can generate must be adjusted to realistic levels or off-farm income may be needed to meet family needs.

Farms with no debt are best positioned to weather financial adversity as they can draw on savings or unused credit to pay for unexpected expenses and support the family through low-income years. The risk of continued operation during poor-income years is that owner equity may be eroded unless the investment horizon is sufficiently long to recoup losses. Prolonged periods of low prices and yields might be expected to prompt some older producers with no debt to choose retirement, perhaps liquidating some assets to generate retirement income.

Farms that have been profitable may be able to continue operations through several low-price and low-yield years. Lenders may be willing to provide credit to help with cash flow problems or the producers may have sufficient savings or off-farm income to survive. Debt levels will rise and loan repayment will place greater demands on future income; or savings will fall and consequently generate less investment income in the future. Until the operation returns to a profitable status, owner equity will decline.

The operations most vulnerable to low prices and yields are the most highly leveraged farms, often with younger operators. For these producers, one or more years of low prices or yields can jeopardize the operation as the need to generate cash for loan repayment and family living expenses is greater than for comparably sized operations with less debt. These producers may contemplate partial or complete liquidation of the farm or ranch.

Chronic financial stress dictates not just an audit, but an overhaul of the farm business beginning with a reassessment of farm goals and priorities. Goals might include protecting owner equity, minimizing losses, staying in production agriculture regardless of the cost to owner equity or orderly liquidation of assets. An honest assessment of whether financial stress is temporary or long-standing is needed. Financial problems may be caused by cash flow difficulties, lack of profitability, insufficient business equity or a combination of these. Strategies for change should be directed at the source of the problem.

If liquidity appears to be the main problem, work on increasing and speeding up cash inflows while decreasing and slowing down outflows (including reducing family spending). If principal and interest payments are part of the liquidity problem, explore alternatives to restructure the level and timing of debt repayment. When profitability is the weakness, consider alternatives that improve production, marketing and financial efficiencies.

If solvency is a problem, but profitability and liquidity are not typically an issue, a difficult situation may correct itself over time. If the solvency position is not tolerable in the short run, investigate giving up ownership of some assets and renting them back or soliciting outside equity capital. PD

—From Oklahoma State University Extension website