‘Risk’ is a word used generously when talking agriculture. And with good reason.
With the current volatility in rainfall, grain, land and input prices, the need for a clear understanding of risk in the farm business is as important as ever.
In many instances growers have a comprehensive understanding of their business’s risk profile. Though on occasion the word appears to be used to describe the ‘too hard basket’ of unknowns that growers are facing in this era of deregulated markets and climate change.
This article aims to touch on the most impacting risks and risk mitigants within the farm business, as viewed by the author.
1. Ownership and Succession
Farming has always been very capital intensive, and the level of capital tied up in businesses today is significant. The single most important factor in a farm business is asset protection. Without the equity, the game is over.
It is important to understand how the business will fare in the event of a death in the family or a breakdown in the relationship between generations, siblings or spouses. Current owners should take the time to plan for each scenario, whether their priority be the stewardship of the farm into the future, an even split of assets among family members or something different.
These intentions should be clearly communicated to those impacted on and all legal documents (property titles, trust deeds, company shareholdings/directors, wills, binding financial agreements, deeds of family arrangement, etc.) prepared or amended to accurately reflect these wishes. All documents themselves should be understood in great depth. The meaning a layperson takes from a legal document is not always consistent with the eyes of the law.
Farm businesses are too often lost unnecessarily as a result of inadequate asset protection or succession planning.
2. Production
There is an ever increasing body of research to support a number of farming practices which now represent ‘best practice’. In the short to medium term these measures act to maximise profitability by reducing the cost of production and/or increasing the level of production. Time needs to be spent looking at these measures and assessing how appropriate they are for the individual business with consideration for enterprises, soils, climate, level and volatility of rainfall, financial health and whether ownership of the farm will be retained.
These measures should be looked at in detail before implementation and accompanied with sufficient analysis to allow an accurate forecast of return on investment. Without this, it is not possible to know where to invest the limited farm capital for the greatest return. And with a string of bad seasons the ‘greatest return’ may be the difference between staying on the land and moving on.
3. Grain Prices
From an operating perspective, price risk is arguably the most poorly understood and managed risk. The cheapest and simplest opportunity for farmers to increase their profitability comes from better understanding how to market grain: knowing the financial products available, developing a marketing plan and implementing it.
To illustrate the importance of grain marketing a 10% increase in grain prices has been compared to a 10% increase in production. A 10% increase in price attracts no further expenses (end point royalties have been omitted from each calculation). A 10% increase in production requires more harvest time resulting in additional economic depreciation of the harvester and chaser bin tractor, consumption of diesel, additional labour costs (assuming hourly wages) and additional freight and handling costs. It also requires additional nutritional inputs which may not be a direct cost to the season in question but rather a cost to future seasons. So, with the assumptions for additional costs as they are (see Table 2), selling grain at 10% above average price gives a net profit of approximately 10% greater than an increase in production by the same amount. If the cost of nutrition is removed from the equation there is still a difference in net profit of approximately 6%. Production is important and marketing is at least as important. Please see Table 1 below for details of calculations:
In the author’s opinion the two key products which should be understood and utilised are forward (forwards) and swap contracts (swaps). Forwards, commonly referred to as cash contracts, are already widely used while swaps are used less commonly and arguably too sparingly.
Forward contracts give a fixed price for grain and are available approximately one year prior to harvest. Swaps do not give a perfectly fixed price and are available up to three years before harvest. The additional time available to hedge grain price with swaps gives more opportunities to secure above average grain prices.
4. Property Acquisition
Acquiring additional farm land is likely to be the largest financial decision a farmer will make and should be given the appropriate consideration. In recent times two large-scale farmers have shared their philosophies on expansion; only one remains in the industry:
“If someone can afford to pay that much, I can too.”
“It’s cheap today compared to what it will cost tomorrow.”
A property agent also communicated his general rule for current Central Wheatbelt agricultural land prices:
“Take the 2007/2008 price, reduce it by one third and you’ll be getting close.”
Buyers of agricultural land are either in the business of farming, property investment or some combination of the two. If expansion is occurring to improve the profitability of the farm business then the property should be valued on an income basis. That is, what profit can be extracted from farming this land and therefore what is its value?
If a property is said to be ‘worth’ more than its income based valuation it can be assumed that value is ascribed in addition to its agricultural use. This may be due to such things as the potential for subdivision or rezoning for industrial, commercial or residential uses. If a property is to transact above its income based value the buyer is taking on risk as a property investor; making a bet that the land will appreciate. Doing this is fair and well but if you are taking on debt to do this, it may leave you in a compromised position if the seasons play out poorly.
Buying land over its income based value will erode a business’s profitability (return on capital employed). If your aim is to maximise profitability or give the next generation an opportunity, this can be a risky strategy.
Conclusion
A grower recently said to me:
“I’m less of a traditional farmer and more of a full-time risk manager.”
If we want to give our businesses the best opportunity to survive and prosper in this constantly changing landscape, I suggest this is the paradigm shift which needs to be made.
Author contact:
Ty Fulwood
0409377718
fulwood.ty@gmail.com