Good seasons the time for strategic moves
GroundCover™ Issue: 101 | Author: Brian Wibberley
For years I believed, like many people, that the fate of growers rested largely with the seasons. Experience has taught me that successful farming is more about the financial management decisions we make.
Certainly seasonal variations and commodity price fluctuations have an impact on annual profitability; however, over a longer period of time how successful you are depends largely on the decisions you make during the good times.
Farm expenses, such as fertiliser, sprays, fuel and overheads remain very much the same from year to year (after allowance for inflation). What fluctuates dramatically in farming is annual income, based on varying seasonal conditions and yields, and commodity prices.
The farm management decisions that are made during good periods are the keys to success in the long run.
Unfortunately, we often see cash surpluses in good seasons turn a conservative, rational farm manager into a spendthrift without thinking or planning for the consequences of these decisions.
Managing the farm business is very much the same as playing chess. First, you need all the pieces. The next and most important thing is that you need to know how to move the pieces in a coordinated, effective manner. We consistently see a failure to do this.
I have the opportunity to review the financial affairs of many growers. Usually people have most of the pieces; however, in nearly all cases both farming families and their professional advisers are not moving the pieces in the right manner to win the game.
This is especially true during the good, profitable periods like those experienced recently in parts of southern Australia.
So for those farmers who are not moving their pieces in the right manner, now is the time to rethink the strategy, because it will not only set them on the right track, but also future generations.
Inevitably there are poor seasons not far away. Whenever a farmer puts in a crop there is a chance that it will be a poor year. Given this scenario, many of my experienced clients, who have no illusions about this possibility, take advantage of poor years, using these as the time to buy equipment or extra land.
To do this requires preparation during the good seasons.
What do you need to do?
First, make sure you have all the right pieces, including:
- flexible asset ownership and operating structure(s) – the best structures are discretionary trusts with corporate trustees, and an operating trust for the business entity that is separate from the asset-owning entities (which protect the assets in tough times);
- n a finance facility that provides financing flexibility in times of need and for taxation management;
- farm management deposits (FMDs) – every farmer should aspire to have the maximum they can in FMDs, currently $400,000 per person;
- self-managed superannuation fund or family superannuation fund – these are essential for accumulating assets for retirement, handing the farm over to the next generation, tax planning, retirement funding and estate planning;
- an equipment replacement policy and plan – equipment expenses are ongoing, and escalating machinery prices make this a major finance decision;
- business income and wealth protection insurance to protect your income flow, assets and your family; and
- a succession plan and an estate plan.
Do not get caught having all of the pieces and not knowing how to move them to your advantage. Often people have professional advisers who know about all the pieces. But do they know how to use them?
This is often influenced by the grower’s own ‘game plan’, which depends on not just the financial situation, but also short and long-term goals, the desires and demands of the family, and attitude to risk.
‘Where do you want to be in five to 10 years?’ is often the most important question.
No one solution fits all the farm family needs, so you need to sit down with your consultant, accountant and bank manager and develop a plan. The best time to do this is during the good times when you are able to be positive in developing your future direction over the full range of seasons.
Once you have a basic plan you can then look at the ‘what ifs’ associated with the seasons, prices and changes in family circumstances, and thereby manage the uncertainties that will inevitably come.
The greatest mistake is to have no plan.
And then once you have the pieces, the game can start.
I will use the example of Grower A and Grower B. I should say from the start that this example is simplistic and in the real world needs to take account of factors such as farm debt and debt servicing requirements, stage of life and goals. But simple examples can help our thinking.
Grower A is conservative and avoids borrowing where possible, preferring to pay cash, especially for purchases such as plant and equipment.
He avoids his accountant where possible, thinking the fees are far too expensive, and Grower A has no idea of his current year tax position.
His plant is in good condition; however, it is ageing and, as a result, its resale value has dropped in recent years.
Grower A knows he needs to upgrade some of his main cropping plant, and although shocked at the trade-in price offered for his old plant compared to the price of either secondhand replacements, or new gear, he decides to use $200,000 of his cash reserves to upgrade and buy a good second-hand header.
Grower B and his wife, on the other hand, are conscious that machinery breaks down and inefficiencies of operation can affect their annual profits.
Further to this, they understand that timely, efficient operations not only reduce operating costs such as labour, fuel, repairs and maintenance, but also reduce production risks due to adverse seasons.
Like Grower A he is conservative and does not like borrowing; however, his farm management adviser has convinced him that it is critical that he conserve his cash and manage his income tax.
As a result Grower B deposits $200,000: $100,000 for himself and $100,000 for his wife into FMDs with five per cent annual interest.
Grower B then decides to buy a new header for $400,000, paying an upfront deposit of $50,000 from cash flow and borrowing the rest on a chattel mortgage over a five-year term with a residual of $120,000 (30 per cent) at an interest rate of seven per cent. This equates to annual payments of $60,000.
Now consider what happens to Grower A and Grower B in two different scenarios.
Scenario 1: Two subsequent poor years
Grower A owns his harvester and does not need to meet any financing costs.
His $200,000 of cash reserves is tied up in the machine and after the first poor year he has to ask the bank for an extension on his overdraft to fund operating costs and to pay his tax on the previous good year. The loan is secured by his farmland.
After the second poor season he requires a further finance extension to cover the cropping costs for the third year, not knowing what the outcome of the year will be. By this stage he has lots of carried-forward tax losses.
Further, the second-hand machine that he bought privately with no warranty or back-up is getting a little long in the tooth, increasing the risk of breakdown.
Although he spent $40,000 reconditioning the header before the second-year harvest, he has a breakdown during harvest that costs him a week and a half of good harvesting weather, which is followed by two days of rain, downgrading his crop from H1(southern hard grade) to feed.
Things are not looking good. He has gone from a solid financial position with no debt to an escalating overdraft in year three. He also has a deteriorating header, which has significantly increased his production risk.
Grower B has to pay his $60,000 annual payment on his machine.
He is in a strong financial position because, although he owes money on the header, he has surplus cash reserves in his FMDs. There is little-to-no security over the farmland.
After 12 months on deposit he and his wife are able to draw down $30,000 each on their FMDs to meet the header payment.
He has little tax to pay on the previous good year as a result of the FMDs tax deduction.
Given his position, he has two options to fund operating costs: either withdraw more FMDs or fund the expense on his overdraft.
His farm consultant recommends that he use his flexible finance facility, as he always has the financial comfort of withdrawing more of his FMDs in the event that the second year is poor.
The FMDs offset the flexible finance facility increase so he is no worse off. All he has to pay in extra costs is the difference between the finance interest at 7.5 per cent and the FMD interest at 5.0 per cent.
After the second poor year he, and his wife have to withdraw $30,000 each in FMDs to cover the second-year header payment.
Once again, unlike Grower A, he has a choice as to whether he withdraws FMDs or extends the finance facility.
Both he and his wife still have $80,000 of FMDs remaining, so they decide to withdraw these.
Their new header, unlike that of Grower A, is still covered by warranty and is in good operational condition. They have spent little to nothing on repairs other than a few belts and oil changes.
There have been no breakdowns and, unlike Grower A, they are able to harvest through, to get their H1 crop off, before the rain.
By the time they get to year three they still have a good header that is worth about $50,000 more than the finance contract payout figure.
So they have retained their equity and they are not exposed to undue production risk from breakdowns.
In contrast to Grower A, they owe very little on their flexible finance facility, so the equity in their farm is safe.
Overall their financial risk exposure is far less than that of Grower A.
Scenario 2: Two subsequent good years
Grower A is laughing. His cash reserves have recovered after the second-hand header purchase and he does not owe anything. He was a little shocked at his tax bill but did not worry about it, as he had sufficient cash to pay the liability.
He spends his $40,000 reconditioning the harvester prior to the second year and suffers a breakdown during harvest as he did in Scenario 1.
The value of his crop is downgraded from H1 to feed, costing, on his estimate, $200,000.
With the repairs and maintenance on the old machine and loss of crop value at harvest, his cash reserves have dwindled. One good aspect is that he does not have much tax to pay.
Although in a sound financial position, his wealth has deteriorated due to his older plant and he is faced with the increasing changeover cost between the trade-in value of his old machine and the cost of a replacement header.
Grower B is also laughing. Not only have his cash reserves increased he has been able to leave his FMDs intact.
Further to this, after paying his $60,000 machinery payments and funding the next crop he still has surplus cash.
His farm adviser suggests he increase his FMDs as a further tax reduction to manage his income tax liability. He decides to deposit another $100,000.
There have been no undue requirements in regards to repairs and maintenance, and the header is in good condition. He has no problems in the second-year harvest, as he was able to get his H1 crop off before the rain.
His financial position is now very strong. He and his wife now have $500,000 in FMDs and they have a good header providing them comfort in regards to their production risk.
Grower B has in fact been exposed to less risk than conservative Grower A and has accumulated far more wealth, which can now be used to expand, increase their superannuation or take it easy.
Yes, as I said at the start, the example is simplistic, but it demonstrates the need for careful planning in the good years to give the best long-term outcome.
This article was produced by Brian Wibberley, Wibberleys Pty Ltd, for the Eyre Peninsula Farming Systems Winter Newsletter 2012. With thanks to Geoff Thomas, Andy Bates and the GRDC-funded Low Rainfall Collaboration Profitability and Risk Project.
Region National, South