MT. JULIET, Tenn. (DTN) -- When it comes to farm business strategy, there's no silver bullet that guarantees success. However, data consistently shows that small improvements can have a compounding effect.
"There are lots of little things: keeping costs in check, continuing to market and take advantage of opportunities," said Pauline Van Nurden, an Extension economist with University of Minnesota's Center for Financial Management. "We talk about the 5% rule, and it really just means that lots of little things add up to make a big difference."
Retired Texas A&M University ag economist and former DTN columnist Danny Klinefelter popularized the approach to thinking about farm finances. Essentially, he argues that a 5% increase in prices received, a 5% decrease in cost and a 5% increase in yield will often produce more than a 100% increase in net returns. What's more, the effect is cumulative, multiplicative and compounding.
"It really sets the stage to maintain profitability even as you experience that cyclical nature within agriculture," Van Nurden said. "So, it may not seem as important today, but over time, it adds up as you manage through all of those up-and-down cycles."
In this special DTN series, we explore a variety of ways farmers can "Keep the Good Times Rolling" by making smart investments and business decisions during these times of strong commodity prices that will pay off when the price cycle heads lower. This story, the fifth in the series, discusses ways farmers can improve their business' financial standing, whether that's by building working capital, thinking critically about your cash flow or investing in income-producing assets.
BUILD CASH RESERVES
U.S. farmers rapidly built their cash reserves amid the early years of the ethanol boom, and those that did were thankful for the additional liquidity during the lean years. Now that prices are at some of the most profitable levels in nearly a decade, experts say it's important for farmers to replenish those reserves.
Rabobank General Manager Chris Olson said the old phrase really is true: Cash is always king.
"You don't know what the next major obstacle the unforeseen future could bring to us, from a trade perspective or a weather perspective. Whatever it may be, you can never predict the unpredictable," he told DTN. But you can prepare by building your working capital.
Working capital is a simple equation: current assets minus current liabilities. Farmers can increase their working capital by reducing debt or by increasing their assets.
"We always joke that the way to build working capital is to make money and not spend all of it," Van Nurden said. "What we mean is when you do have profits, don't make capital purchases with cash reserves. Still seek out financing, and don't put things on your operating line. Watch family living expenses. It's easy once we make more money to spend more money."
Minnesota farmers increased working capital significantly in 2020, according to the annual FINBIN Report on Minnesota Farm Finances. The FINBIN database includes 2,330 Minnesota farms that represent 11% of commercial farms with annual sales above $250,000. Working capital increased by just over $111,527 for an average farm (see illustration above). "This 57% increase in working capital was a critical increase after the extremely weak liquidity positions that many farmers faced in recent years," stated the report.
Both Olson and Van Nurden urge farmers to stick to their marketing plans. (For more on marketing plans, please read the fourth piece in this series "Maximize Profit With Smart Grain Marketing" here: https://www.dtnpf.com/….)
"Prices can be fantastic, but if we don't realize them by actually making sales, it's just opportunity cost lost," Olson said. "If we see opportunities where you look at your break-evens and you're making a profit, maybe you need to lock in some sales," he said.
Before farmers can effectively sell a crop, they need to know how much it cost them to produce. But to be savvy marketers, they also need to anticipate what their breakeven will be in the year ahead, so they can make appropriate forward sales if there's an opportunity.
Input prices are likely to rise for the 2022 growing season. Land rents are likely headed higher as landowners seek a share of farmers' profits. Fertilizer, chemical and machinery prices are already much higher than last year because of pandemic-related shortages and increased demand.
"I think we've got to have to temper our thoughts around how much expansion to do or how big of an investment you make in 2022. That working capital number may need to be higher than you anticipated going into this year," Olson said. "We have to be very conscientious whenever we're in a financial boom with great markets. Usually, the input side catches up very quickly but doesn't come down as quickly."
CONSIDER HOW PURCHASES AFFECT CASH FLOW
Van Nurden advises farmers to think carefully about large purchases of land, machinery or other assets. Farmers dislike paying taxes, and in high-income years like this one, it can be tempting to reduce the tax bill by making a large capital purchase and using depreciation strategies.
"It's OK to make capital upgrades and do some of the things you've deferred during the most recent downturn," she said. "Where people get in trouble is when they make capital purchases that maybe aren't as necessary."
If you make a large equipment purchase, for example, and use up most of your bonus and Section 179 depreciation in the first year, you've gotten all of the tax benefit, but likely have to continue making principle payments for five to seven years.
"When profits erode and things get tighter, it's harder to make those payments," Van Nurden said. "It's OK to pay taxes. It means you're making money."
Olson added that it's crucial that you understand the purpose of the purchase and its impact on your cash flow for the length of the lending term.
In some cases, that's easier said than done. Land purchases tend to be emotional, but their bottom-line impact can be large. Typically, bankers can make the case for a land purchase from a loan-to-value standpoint, but it's up to the farmer to make sure it's a good fit for the overall operation's cost structure.
That means evaluating the current debt load and asset base, understanding the financial costs (interest, fees, etc.) that come with carrying the asset and calculating its impact to cash flow on an annual basis.
He suggests ignoring the current boom times in your analysis. Create a forecast using normalized yields and prices and see how a big purchase affects your breakeven. "Did it increase my break-even cost by 50 cents? Now that could be a pretty significant increase in this marketplace today," Olson said.
"There's an old saying: Equity isn't liquidity. Sometimes we try to make that case, and that can put us into an uncomfortable situation when the market does correct itself to where prices will be less than input costs."
INVEST IN INCOME-PRODUCING ASSETS
If you do choose to invest, one thing Olson encourages is investing in income-producing assets. "Is there something you can invest in that gives you a better return to your farming operation?" he said.
Farmers invested heavily in grain bins at the outset of the ethanol boom to help them meet plants' just-in-time needs, to improve efficiency and to capture as much benefit from basis changes as they could.
According to USDA data, farmers built 1.4 billion bushels of on-farm storage from 2007 to 2017. Olson thinks storage expansion and enhancements will continue to be popular investments because they add efficiency to farming operations.
One traditional way farmers have added income-producing assets in the past is to invest in livestock, but current lumber and construction costs might make investing in a hog confinement barn or similar facility less appealing right now.
Another area Olson sees farmers investing in is sustainability projects, whether that's adding solar panels or adopting new sustainable farming practices. Solar can help a farm cut down on energy costs while potentially generating some returns, depending on agreements with local electric companies. States incentivize solar investments in different ways, with some state regulations making them much more appealing than others.
Olson said he's also seen growing interest in various carbon credit programs. While some farmers may be encouraged by the idea of a payment for adopting certain practices, he stressed that's not where the big payoff comes from.
A grower might receive $10-$20 per acre in carbon credits, but while that might be enough to cover the cost of the seed, a more important value may come from the positive impact to soil health.
"Your money is made on improving your soil health, which could ultimately increase yields and decrease your costs," he said.
Through her experience working with farmers and digging into their FINBIN data, Van Nurden said the most successful farmers create good plans and stick to them.
"Don't alter your path," she said. "Use this reprieve to set yourself up for success."
This is the fifth of a six-part special series. Next in the series: We will explore how to get the best return on your investment if you upgrade to new equipment.
You can read more about price outlook in the first article of this series, "Farm Revenue Driven by Chinese Demand, Drought Concerns" here: https://www.dtnpf.com/….
The series also examined what farmers are doing agronomically to boost their production. See our second story, "Farmers Willing to Spend Money on Crops if Yield Potential, ROI Are Promising" here: https://www.dtnpf.com/….
For more on tactics to manage land expenses, particularly cash rent negotiations, please read the third piece of this series, "Contact Landowner Now to Smooth Way for Rent Negotiations" here: https://www.dtnpf.com/….
The fourth piece in this series "Maximize Profit With Smart Grain Marketing" can be found here: https://www.dtnpf.com/….
To see a Reporter's Notebook video about the series, check out https://www.dtnpf.com/….
Katie Dehlinger can be reached at firstname.lastname@example.org
Follower her on Twitter at @KatieD_DTN
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