Jan 17, 2019
THREE NUMBERS TO KNOW
I. Working Capital: The capital available for the business to do its work
[CURRENT ASSETS - CURRENT LIABILITIES] gives you a dollar amount, but t only means something if you put it into perspective with a ratio. So we divide that number by our GROSS REVENUE. Let’s plug in a couple of examples with $1M working capital as an example. A Main Street boutique has a gross sales of $500K. Then 500,000 divided by 1,000,000 gives them 200% working capital to gross sales! On the other hand, General Motors did about $150B last year, so if they only had a million in working capital it give us so small a ratio you’d hardly even be able to measure it.
Most farms are going to be comfortable keeping their working capital above the 30% mark, so that if a farm raises a million in crop sales, that’s having about $300K of liquid assets.
II. Debt Service Ratio: Operating revenue compared to how much
is going to be spent paying debt in a given year
This speaks to the business’s ability to take on and cover debt. If I have a .8 ratio, my business is only generating enough income to pay 80% of its debts. It’s like a household that brings in $100,000 dollars but is spending $125,000. That extra $25k has to come from somewhere—maybe it’s a credit card at a high interest rate, or taking out a second mortgage against equity they have in their home. Essentially, the household can only do this until its assets run out.
The flip side is if our number is a 2.0. That means we are bringing in twice the income as the debt we are paying out. We’re in a comfortable spot, and if we need to take on more debt we have some flexibility.
III. True Breakeven: It’s about getting to a per-unit of production cost—not just our inputs—but a real picture.
If I own several factories that produce paperclips, I’m not looking at my cost per building as much as I am looking at my cost per clip. But if I’m wasting money in my building, then my cost per unit will go up. But simply looking at cutting costs at the building level could increase my per-clip cost. Maybe I have a high-priced plant manager—the bean counters see that salary as a great way to cut cost. The plant manager goes, wage cost per building goes down, but so does productivity. My cost per clip just went from 1 penny to 1.2 pennies because we were too focused on saving on building costs.
For the farm, one of the elements that creates a true breakeven is adding in the non-cash cost of machinery use. Every crop I raise is requiring the use of the equipment I own—whether I’ve bought equipment this year or not. So we want to reflect that in our cost per unit. What our advisors do is take the total equipment value owned by the farm, divide by 10 and add that onto our annual input costs. This ensures that each crop is contributing in a way the replaces the machinery it has used.
The one caveat in break-even forecasts is you are going to have to estimate yields. This uncertainty for some can lead them to not even want to think about break-evens until they know how many bushels they have in the bin. But this is where history can help. We start from looking at our last five year of yields, then throw out the high one and the low one. This at least gives us a start—then we can begin looking at what 5% better yield looks like… 5% worse… and so on.
THREE DOCUMENTS TO MASTER
I. Balance Sheet
This is an annual tradition for anyone who owns a business. In fact it’s something households should do, even if they aren’t a business. It’s a statement that gives you a snapshot in time of the assets of the business, the liabilities of the business and the resulting equity of the owners. It’s what you own minus what you owe. Typically this is done at the end of the fiscal year of the business—the consistent time of year allows for year-over-year comparisons of the operation.
The balance sheet is a foundational document that every business needs to be on top of, but the challenge with it is that it is rear-looking. It gives you a picture of what has happened, where we’ve been and what the trends look like—as well as insight into risk-bearing ability for the operation—but doesn’t give you a picture of the future.
II. Projected Cash Flows
This is a forward-looking schedule of when major costs are going to be incurred—like land payments or input purchases—as well likely revenue from things like crop sales. This helps us to plan for the biggest demands on our operating line and be more proactive in our management of the lifeblood of our business: cash.
III. Accrual Income Statement
When I use the term “accrual” in the farm context, I’m thinking in terms of the crop year for farming. If we use the same information we create for tax purposes, which is typically calendar-year based, we will struggle to make effective management decisions. When using a crop-year approach, I’m pulling in all of the expenses that go into the crop and all of the revenues that come out of it. That could easily cover three calendar years in the process.
This is important because if I’m going to make sound management decisions, I need to correctly value what is going into and coming out of each production batch—in this case, the crop. To go back to the manufacturing example, if a batch of hats takes me a week to make, I can’t just look at what materials I happen to buy that week and what revenue happened to come in that week; I need to tie the inputs for those hats, even if they happened many weeks earlier, along with revenue of those hats, even if they happen many weeks later.
Farming is manufacturing—it simply takes us a lot longer for each batch we’re making. Utilize the forecast to make adjustments and run “what-if” scenarios so you make more effective management decisions along the way.