1. Agribusiness Library LESSON L060066: MANAGING FINANCIAL RISK

2. Objectives 1. Describe factors that influence financial risk. 2. Define financial diversification, and explain its fundamentals. 3. Explain enterprise diversification in agriculture. 4. Describe the role of flexibility in managing financial risk.

3. Terms Correlation of investments Degree of leveraging Enterprise diversification Financial diversification Financial portfolio Financial risks Geographic diversification Loan terms Portfolio model Production economies

4.  Financial risks are uncertainties about the ability to meet financial obligations.  They arise from financial claims on the business.  Financial risks are associated with the use of borrowing and leasing to fund the business.  Factors that influence financial risk may include:

5.  A. Degree of leveraging refers to the amount of borrowing a business does against its owned assets.  1. The greater the degree of leveraging, the more difficult it is for a business to meet financial obligations to lenders.  2. If a business believes that the money it borrows can be put to use making more money for the firm while still paying its financial obligations, it may choose to increase its degree of leveraging.  3. However, the firm takes a risk in borrowing money.  The potential payoff of using the money to increase profits should outweigh the cost of having to borrow the money.

6.  B. Loan terms are comprised of factors that influence the availability of borrowed money and the cost to borrow it, such as interest rates and the loan duration.  1. Most of these factors are not under the control of the borrower.  The terms are set by lending institutions and government agencies.  2. Although a borrower cannot control most of these factors, he or she should be aware of industry trends and market conditions that influence these factors.

7.  Financial diversification is the process of holding multiple assets to minimize the total effect of variations in their returns.  A popular cliche for financial diversification is “Do not put all of your eggs in one basket.”  Diversification is important to risk management because assets are spread among a variety of types, enterprises, and income-producing activities without sacrificing investment returns.  As a rule, higher risk investments usually involve higher potential returns, while lower risk investments usually come with lower potential returns.

8.  A. A financial portfolio identifies a mix of assets, enterprises, and investments.  1. It is often used to describe a combination of stocks and bonds owned by one person.  2. A financial portfolio can also be used to describe the holdings of tangible assets by an agribusiness (e.g., grain inventories, growing crops, livestock, machines, land, and structures).  3. For example, a grain-livestock producer has his or her portfolio spread or diversified among grain and livestock.  If the producer raises different crops and livestock, the portfolio is more diversified.

9.  B. A portfolio model is a tool used to indicate how different degrees of investment diversification may reduce an investor’s risk as opposed to having a single investment.  The following are factors that influence if a risk is reduced through diversification.  1. Typically, having more investments and possessing different types of investments decreases risk.  However, nothing eliminates risk.

10.  2. The correlation of investments is the mutual relationships between different investments.  a. The more alike investments are, the greater the risk.  b. Investments that are not closely related in kind are less likely to react in similar ways.  For example, when grain prices are down, livestock production costs decrease, and the livestock producer has more profits.  Diversification allows an investor to spread the risk between the two types of operations.  3. Changes in costs and returns, as a result of diversification, also influence risk reduction.  a. Diversification may involve added costs to buy new equipment and facilities.  b. Investors must weigh the added cost against the potential reduction in risk achieved through diversification.

11.  Enterprise diversification refers to the undertaking of a variety of business projects by an agricultural producer.  It is the traditional approach to risk management in agriculture and is based on the principle that the returns on investments in individual and different activities will stabilize overall returns.  When the income of one enterprise is low, the income from another is high.

12.  A. Enterprise diversification in farm businesses should be carefully considered.  On a local level, crop diversification is difficult because of weather conditions.  As a result, the level of diversification among producers is lower, so the risk is higher.  Combining livestock and crops is likely the most promising approach.

13.  B. A major problem associated with enterprise diversification is the loss of production economies.  Production economies are the savings in production costs as a result of specialization.  A firm or business that specializes in producing a specific product should be efficient.  As efficiency increases, the unit cost decreases.  When a producer diversifies, efficiencies are lost and costs rise.  This increase in costs must be weighed against the expected reduction in risks associated with diversification.

14.  C. The geographic scope of the farm business is also a form of diversification.  Geographic diversification involves spreading production over a wide geographical area.  For example, lettuce growers have spread their production among several western states.  This effort has stabilized their annual incomes and the total amount of lettuce produced and made available to consumers.

15.  Greater flexibility in the business enables the manager to respond more quickly as new information becomes available.  Flexibility does not reduce risk; it provides a means for coping with risk.  The following factors influence flexibility.

16.  A. The relation of fixed costs to variable costs will impact business flexibility.  1. To increase flexibility, fixed costs must be reduced in relation to variable costs.  Producers who organize their enterprises to use more labor relative to investments in capital will increase their flexibility.  2. A hog producer who chooses an investment in a specialized confinement facility over a pasture system that uses more labor reduces flexibility.

17.  B. Another way to achieve flexibility is to choose non-specific resources over specific resources.  1. General purpose buildings, dual-purpose animals, and multi-purpose inputs assist an enterprise in gaining more flexibility.  2. The producer who constructs a building with one purpose has less flexibility than a producer who constructs a multi-purpose building.

18.  C. Behavioral attributes in managers are also important to flexibility.  1. Managers and firms that are able to recognize needed changes and make them aid in flexibility.  2. These attributes have been used successfully by smaller firms competing with larger firms.  The smaller firm managers are able to make changes more quickly than their competitors because of a lack of multiple levels of decision making that is common in larger firms.

19. REVIEW What are some of the factors that influence financial risk? What is financial diversification? What are its fundamentals? How do agricultural enterprises use diversification to reduce risk? What role does flexibility play in managing financial risk?