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Assessing Your Farms Risk-Bearing Capacity: The Foundation of Effective Risk Management Gayle Willett Pacific Northwest Risk Management Education Project.

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Presentation on theme: "Assessing Your Farms Risk-Bearing Capacity: The Foundation of Effective Risk Management Gayle Willett Pacific Northwest Risk Management Education Project."— Presentation transcript:

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 1.Nature (time, weather, disease, pests, etc.) 2.More volatile weather patterns 3.Highly competitive (price takers, not price setters) 4.Globalization of markets Agricultural Production is a High Risk Business and its Getting Riskier.

3 Farm Act Producer Reactions: n Enthusiastic about greater flexibility More flexibility in crop selection. n 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 rMore 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 21 st century.

8 rObjectives of Discussion 1. Outline Four Basic Tasks of Effective Risk Management. 2.Demonstrate How to Determine Risk Bearing Capacity Through Use of: n Financial Statements n Financial Analysis n Enterprise Budget n 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 rReturns to Effective Risk Management Should Increase in Years Ahead rEffective 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. n Each task is equally important. n Ineffectiveness in a particular task causes triangle to collapse.

12 RISK MANAGEMENT FRAMEWORK Risk Management Plan Risk Management Tools Farms Risk Bearing Capacity Sources of Risk

13 ANALYZING YOUR FARMS RISK BEARING CAPACITY Implies understanding the impact of adversity on the farms: Liquidity Solvency Profitability Repayment capacity Financial efficiency Financial Survivability in a Period of Adversity Risk Bearing Capacity =

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 and ). +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 n Financial Analysis Liquidity Solvency Profitability Repayment Capacity Financial Efficiency n Enterprise Budget n Whole Farm Cash Flow Projection

19 Meet Profit Farms r1,500-acre dryland grain operation. rOperated by Max and Marlene Profit. rSole proprietorship, calendar year, cash tax reporting. r1,200 acres owned and 300 acres leased on a 1/3- landowner, 2/3-operator agreement. rRotation is summer fallow - winter wheat - spring barley. rWinter wheat yields have ranged between 37 and 82 bushels per acre over the past 10 years and averaged 62 bushels. rBarley yields have varied between.75 and 2.1 tons per acre, and averaged 1.25 tons over the past 10 years.

20 rFinancial statements and analysis include: n Balance sheet for 12/31/X1 n Balance sheet and supporting schedules for 12/31/X2 n 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 rBalance Sheet The Starting Point in Determining Risk Bearing Capacity n Shows assets, liabilities, and net worth on a particular date (financial Snapshot). n Should be prepared at least one time annually at end of accounting period. n Format (Farm Financial Standards Council Recommendations).

22 Balance Sheet Profit Farms 12/31/X1

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

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

31

32 BALANCE SHEET SUPPLEMENTARY SCHEDULES Max and Marlene Profit 12/31/X2

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37

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 Example: Sell $10,000 wheat, pay $2,000 current debt and put $8,000 in checking account. Impact on balance sheet? Balance sheet reflects outcome of all previous decisions and transactions

43 Current $10,000 Wheat 8,000 Checking $ 2,000 Current NW=A – L NW=$2,000 – $2,000 =0 Current $2,000 Accnt. Pay. $2,000 Current Assets Liabilities

44 Financial Statements (cont.) rIncome 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: n Revenues are recognized only when cash is received. n Expenses are recognized only when payments are made for inputs. Accrual: n Revenues are recognized when commodities or services are produced (e.g. when grain is harvested). n Expenses are recognized when inputs are usednot when they are paid for. n Insures matching of revenues and expenses during accounting period.

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

47 Beginning Balance Sheet 12/31/X1 Ending Balance Sheet 12/31/X2 Cash Records (X2) Accrual Adjustments Accrual - Adjusted Income Statement (X2) + = 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

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54

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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

63 Sources of Change in Owner Equity n Due to retained income (= NI – WD) n Due to contributed capital n Due to personal net worth n 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/-capital distributions – Ending net worth (cost basis) = Residual withdrawals $ 557, , ,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

72 STATEMENT OF CASH FLOWS Max and Marlene Profit Year Ending 12/31/X2

73 STATEMENT OF CASH FLOWS, (cont.)

74

75

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? Measures of Liquidity: 1.Working Capital = Current Assets – Current Liabilities Profit Farms: =$140,603 – $116,896 =$ 23,707 Ability of farm to meet cash obligations as they come due without disrupting the business. Focus is on short run. Liquidity =

81 Measures of Liquidity,( cont.): 2.Current Ratio = Current Assets Current Liabilities Profit Farms: = Industry Standards for Current Ratio: Green Yellow Less than 1.1Red = 1.20:1

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 Ability to liquidate assets and pay off all creditors. Solvency =

83 Measures of Solvency, (cont.): 4.Debt-to-Asset Ratio = Total Farm Liabilities Total Farm Assets Profit Farms (Market): = =0.32:1 (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) Returns to various farm resources, including unpaid labor and management, equity capital, and total capital. Profitability = Returns to Operator and Family Labor, Management, and Equity Capital 5. Net Farm Income=

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 0Red

86 Measures of Profitability, (cont.): 7.Rate of Return on Farm Equity Profit Farms: = –1.1% Industry Standards: Over 15%Green %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 %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 q 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 qDevelop Projected Whole Farm Cash Flow Budget

98 oDevelop 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 Plan Sources of Risk Risk Management Tools 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 RISK MANAGEMENT FRAMEWORK Risk Management Plan Sources of Risk Risk Management Tools Farms Risk Bearing Capacity

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

107 4. Technology Risks n Keep informed about new developments n Periodically analyze the economics of new technology n Rent machinery 5. Casualty Loss Risks n Use property insurance

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

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

110 SELECT AND IMPLEMENT RISK MANAGEMENT PLAN qFinal Task in Risk Management Process qProducers Who: n Understand risk bearing capacity of business; n Have identified and prioritized sources, of risk; and n 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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