LIC | Resilience in farming: a financial perspective


Resilience in farming: a financial perspective

by Eric Jacomb, FarmWise Consultant

Low dairy prices combined with the impacts of last season’s drought (plus high risk of drought this season) are putting the pressure on farm systems and highlighting the need for resilience. Many farmers are assessing how resilient their farming business is, and with the pressure expected to remain for some time, looking at how they can improve. My definition of a resilient farming business is one that has the strength to withstand financial, environmental and climatic stressors, and come out in a productive position with a balance sheet in good shape.  Good financial understanding and management can go a long in way helping to use debt wisely to attain business goals. 

Key factors in assessing financial resilience

A simple way of looking at financial resilience is to benchmark a business against others – looking back on financial accounts and also forward with forecast budgets. The data referred to in this article for benchmarking examples is from the DairyNZ Economic Survey 2013/2014.  Dairybase and Redsky can be used also.

Benchmarking highlights areas of difference, opportunities and risks. Assessing trends over several years is generally preferred as farmers tend to spend more with higher milk prices.

Debt to asset ratio

Fundamentally, the higher the debt/asset ratio the less resilient a business is – due to the higher risk in committing to pay interest on debt.  Businesses with higher debt (shown on right of Graph 1) are more at risk of being sold up or required to obtain outside equity, and paying a higher interest rate.

Debt to Asset Graph

Graph: Debt to asset distribution (Dairy NZ Economic Survey 2013/2014)

Cash flow and liquidity

Cash flow is simply the cash coming into a business and cash going out.  It indicates the ability to meet commitments on an annual basis. The current low levels of advance payments and retrospective payments are making dairy businesses less resilient, so cashflow timing is also important in assessing a business’ ability to operate within overdraft limits. Liquidity is the ability of a debtor to pay debts as they fall due.

Capital expenditure, drawings and taxation also need to be considered.  Interest coverage ratio is used to determine how easily a business can pay interest expenses on outstanding debt. This is calculated by dividing business Earnings before Income Tax (EBIT) by the business interest expenses for the same period.  The lower the ratio, the more the business is burdened by debt expense e.g. 1.5 or lower will mean a questionable ability to meet interest expenses.

In rural lending, drawings, tax and minor capital expenditure (for plant replacement) are subtracted from EBIT before calculating interest cover.  For forecast budgets, the status quo interest rate has a significant impact on this ratio.  An interest cover of 1.00 indicates no free cash, while 1.5 indicates the free cash equates to half the interest bill.  Interest cover is more useful than the commonly quoted debt/kg ms, interest/gross farm income ratios as it includes drawings and plant replacement.

Operating profit

Operating profit provides the best indicator of how profitable a business is. It includes depreciation but excludes debt servicing. Comparing operating profit per hectare, per kg milk solids and per capital percent are all useful measures for benchmarking.

Cash breakeven milk price

This is simply the sum of Farm Working Expenses (FWE) plus interest and rent; less stock and other income.  FWE of $4.00/kgMS plus interest and rent of $1.00/kgMS, less stock sales of $0.30/kgMS and other income of $0.30/kgMS provides a cash breakeven milk price of $4.40/kgMS.  Drawings, tax and minor capex can then be added to determine what milk price a business can sustain without increasing debt.

Financial management

Proactive, good quality budgeting, monitoring actuals to budget, reporting to financiers, consulting with advisors, and governance all contribute to financial resilience.  Manage banking relationships in a positive manner is key to this.  Financiers do not like surprises – particularly negative ones.  Keep them in the loop. 

This article has focussed on financial resilience but having plans and systems in place to manage risks such as death or incapacity, drought, flooding, disease and earthquakes are all part of a resilient business.  We are seeing a push for improved governance in farm business.   Managing risk is a key component of that.

 

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