Farm business management tools

Author: | Date: 11 Aug 2015

Take home messages

  • For a sustainable business, monitor annually farm business liquidity, efficiency and changes in wealth.
  • Good farm business managers have records that go well beyond their tax return.
  • These are all explained in ‘Farming the Business’, a manual in farm business management (more information at Farming the Business Manual).

Key profit drivers

The classic response to the question of ‘what are the profit drivers of a farming business?’ would be to list the greatest impacts as the following:

  • Commodity prices.
  • Actual crop yields and quality and relative livestock profitability achieved.
  • How well farm business expenses are matched to production.
  • The matching of farm resources to the scale of the operation.

Essentially, profit is what is left over after covering the costs of running the farming operation for a year. Simply, the formula for profitability is:

Profit = (production x commodity price) – annual costs

So those items that have the greatest impact on profit are the commodity prices that are achieved, the amount of commodities produced and what it costs to run the business in that year.

One way of assessing the relative impact of these items on profit can be shown by using a mixed farm case study (based on figures typical of many mixed farms). Imagine the result if each production, commodity price and cost item that could affect this farm’s profit were isolated and changed by five per cent. This is a sensitivity analysis. The results shown in Figure 1 indicate the relative importance that a five per cent shift in each variable has on business profits.

Figure 1: Profit effect with a five per cent change in factors.

Figure 1: Profit effect with a five per cent change in factors.

A few observations from this sensitivity analysis on impacts of individual factors on farm profit:

  • Exchange rates have the biggest relative impact on profit because they influence all commodity prices that are dependent on exports, which is 90% of this farm’s production.
  • In relative terms, commodity prices (in brown) and yield changes (in green) have the next biggest impact on profits.
  • Interestingly, changes in cost items (in blue) had a lesser impact on profit.
  • Also the interest rates ranking depends on the level of debt. In this example, the equity level is at 85%.

So, those items that have the greatest impact on farm profits are exchange rates, commodity prices and enterprise yields. What makes this result even more significant is that commodity prices and yields generally vary far more than five per cent between seasons, while costs generally vary by the inflation rate of about 2.5 per cent, indicating that commodity prices and yields are even more important to profits.

Growers have a greater level of control on costs, compared to other factors. So it is easy to see why often much of their focus is on managing costs. However, one could conclude from the analysis in Table 1 that 80 per cent of management should go into managing prices and yields and only 20 per cent into managing costs. However, the farming business is complex and this analysis is too simplistic! A greater understanding of essential farm business management is required.

Other equally important drivers of business sustainability

Sound farm business management is about looking at the farm business as a whole. This includes the following measures:

Gross margins

Figure 2 shows an example of a whole farm business analysis where the gross margins of each enterprise are understood and overhead costs are assessed to determine the ‘Net Farm Income’, otherwise known as profit. A sustainable farm business is one that continually achieves profits which can then be invested either off-farm or on-farm in projects to further improve the farm’s profitability.

Through the Farm Business Updates, GRDC has embarked on a program to encourage growers to have access to resources to better understand the relative gross margins of each of their farm enterprises. This gross margin initiative is to coordinate and promote collaboration of the efforts of various providers of gross margin tools and resources in NSW, Victoria, SA and Tasmania.

Figure 2: Whole farm analysis.

Figure 2: Whole farm analysis.

Whole farm analysis

A whole farm analysis will provide greater understanding of where the profits are being made in the business and indicate where profit improvements can occur. If a business is to be managed sustainably, the following financial measures should be planned for and closely monitored:

  • Liquidity – this is an understanding of the cash flow of a business, to ensure that bills and commitments can be met in a timely manner.
    Is there enough cash to meet business commitments?
  • Efficiency – this helps determine how well the assets are being managed in business and if they are competitive with other uses for that capital. A return on managed capital is a good measure of business efficiency.

Is this the best use of our resources?

  • Wealth – this is very important for the sustainability and risk management of a business. It is the measure of ‘net worth’ and seeing whether it is sufficient to achieve the business’ goals.

Are our assets growing over time?

There are a number of farm business management tools available to help plan and monitor these three important financial measures, shown in Figure 3.

Figure 3: Important farm business management tools for whole farm analysis

Figure 3: Important farm business management tools for whole farm analysis.

It is important to note that the profit and loss, and balance sheet in a farm business tax return are completed using the Australian Taxation Office (ATO) rulings, and are not a substitute for completing a farm business management profit and loss, and balance sheet. These important tools and concepts are covered in the GRDC Farming the Business manual, a reference listed at the end of this paper.

These three concepts of liquidity, efficiency and wealth are the basis of sound farm business management, and best worked on through a annual planning cycle. Once these have been developed, more advanced farm business management tools and concepts can be used to answer more specific questions.

The annual farm business planning cycle

The financial tools of cash flow, profit and loss, and balance sheet should be undertaken annually, initially as a plan for the season. Then as the season unfolds, actuals can replace the plan. At the end of the season a set of ‘actuals’ (i.e. cash flow, profit and loss, and balance sheet) should be completed. This planning cycle, shown in Figure 4, will clarify management of the business so that it can optimise profits and improve sustainability.

Figure 4: The yearly planning cycle.

Figure 4: The yearly planning cycle.

The actuals at the end of the season are important to complete so that both ‘what worked’ and ‘what didn’t work’ can be assessed, to help inform the plans for the following year. The cycle then starts again.

Advanced farm business management tools

Advanced farm business management tools include:

  • Scenario analysis – this is the ‘what ifs’ and can be compared so that correct decisions can be made. Ideally the budgeting tool used by a farm business should accommodate this.
  • Bank financial performance ratios – there are a number of bank financial ratios that can help measure the financial strengths and weaknesses of a farm business.
  • Partial budgets – these are a simplified version of a ‘what if’ analysis where specific aspects of the business are measured to assess whether a business idea has merit. The advantage of this tool is that it is relatively easy to use. Gross margins are often one of the key resources that assist with this type of analysis.
  • Cost of production – this tool allows a business to understand their cost of producing a commodity, such as a tonne of grain, a kg of wool or meat, so that selling decisions can be made knowing what profits are potentially being made.
  • Break-even budget – this is similar to a cost of production assessment as it provides a selling and production guide as to what needs to be produced to develop at least a break-even result. More importantly, it measures what commodity price and production levels are needed in order to maintain profitability.
  • Simulation modelling – this is where probabilities of various outcomes are taken into consideration. Using products such as @Risk, modelling is possible to provide the decision maker with the probability of a likely outcome.

How do you undertake these budgets?

There are two ways farmers and advisers can undertake these various farm business management measures:

  • Spreadsheets – you can educate yourself or get your adviser to develop these tools using software spreadsheets like Microsoft Excel.
  • Commercial software programs – you can educate yourself or get your adviser to use P2PAgri, which can develop all of these tools, with the exception of @Risk, which is specifically used with Microsoft Excel. If you are just interested in cash flows, then the major farm accounting software packages like Phoenix and Agrimaster could be used.

Training opportunities

If you are challenged and excited by the possibilities of improving your farm profits, then check out the training and software support provided by P2PAgri. GRDC is actively encouraging both advisers and farmers to use this unique whole farm business planning and monitoring software. The various farm business management training opportunities are:

GRDC Farming the Business manual, a recently released farm business management manual for farmers and their advisers which covers all these tools in more detail. This manual comes as a traditional book, an e-book in the iTunes store or a series of pdf files. This is freely available with more details on Farming the Business Manual or at P2PAgri.

‘Farming the Business’, a recently released farm business management manual for farmers and their advisers which covers all these tools in more detail. This manual comes as a traditional book, an e-book in the iTunes store or a series of pdf files.

GRDC 4-day ‘Advanced Farm Business Management’ courses for agronomists, farmers and business advisers. This includes the P2PAgri software.

4-day ‘Advanced Farm Business Management’ courses for agronomists, farmers and business advisors. This includes the P2PAgri software.

GRDC 2-day ‘Plan to Profit’ farmer workshop, which includes the P2PAgri software.

2-day ‘Plan to Profit’ farmer workshop, which includes the P2PAgri software.

GRDC 1-day ‘Farm Business Management Essentials’ workshops for farmers which teaches how to read tax returns and turn them into a useful set of profit and loss, balance sheet and financial ratios.

1-day ‘Farm Business Management Essentials’ workshops for farmers which teaches how to read tax returns and turn them into a useful set of profit and loss, balance sheet and financial ratios.

GRDC 1-day ‘Ri$ky Business’ is a farm simulation game developed by the University of WA, which immerses participants in the various farm business management tools to experience how they help with making business decisions.

1-day ‘Ri$ky Business’ is a farm simulation game developed by the University of WA, which immerses participants in the various farm business management tools to experience how they help with making business decisions

GRDC farm business management fact sheets and other resources from the farm business management section on GRDCs website.

Conclusion

The art of good farm business management is to identify the questions that need to be answered and knowing which of the tools to use. You don’t need to use all the tools, just the ones you need in order to answer your key business management questions. If you do not have the current farm business management skills you would like, you can:
  • Attend the appropriate courses and workshops to develop your skills.
  • Use a skilled adviser to develop these farm business management tools for your business.

The key to sound farm business management is to plan and monitor your business in terms of:

  • liquidity,
  • production efficiency; and
  • wealth generation.

With these tools, you will greatly improve your chance of maintaining a sustainable and profitable business well into the future.

Contact details

Mike Krause
P2P Agri P/L
0408 967 122
Mike@P2PAgri.com.au

www.P2PAgri.com.au

GRDC Project Code: PTP0001,