Budgeting often focusses mainly on cash flow to ensure enough money is available to keep the operation running.
A farm starved for cash can be stressful, which can lead to undesirable outcomes.
As a result, it’s important to work through a budgeting exercise and align cash inflow and outflow.
Capital budgeting is one of the budgeting areas that often doesn’t get a lot of attention. It complements cash flow budgeting but is a somewhat different exercise.
Farmers tell me it is a difficult and sometimes pointless exercise be-cause of uncertainty. When is a machine going to need to be replaced? Will there be a major breakdown that will require a purchase? How do you know if land is going to come up for sale or if a landlord may suddenly decide it’s time to sell? What are the crops and prices going to do?
These are all good questions with of course no sure answers, but the questions are one of the reasons why you should work through an exercise and develop a capital budget.
Part of the capital budgeting exercise is aligning the “what ifs.” What if we buy a tractor in 2013 and add storage and an air drill in 2014? Will we be able to buy the combine in 2015? What will the implications be if there are a couple of poorer crops and we have to defer the combine replacement that’s likely due in 2016? Can the combine decision wait? How old will it be by then and can it wait another year? Maybe the shed and air drill will have to be put on the back burner.
Two ratios can be used to put parameters around the capital budgeting process: the debt servicing ratio and the working capital percentage ratio.
The debt servicing ratio indicates how much earned ability the farm has to make principal and interest payments.
Let’s assume that you are in the second year of a five year rental arrangement and your landlord has indicated he will sell the land at that time. It will require a sizable loan with hefty payments to buy it?.
You will ideally want to manage your capital purchases and their related debt load so that there is debt servicing room for the land deal.
How much cash are you going to use as a down payment? This is money that will come from working capital and directly affect the availability of cash flow that is needed to operate the business, called the cash flow budgeting connection. You may need to increase your working capital over a couple of years so that you have the cash available for the down payment.
The exercise should not take too long to complete and after the first effort, each subsequent year requires only that you add another year.
A capital budget is not set in stone. Things happen and plans change. Simply adjust the budget to reflect the changes.
You do not have to share your budget with your lenders, but they will be pleased to learn what you might be thinking about when it comes to capital purchases to help them structure financing to meet your needs.
Terry Betker is a farm management consultant based in Winnipeg, Manitoba. He can be reached at 204.782.8200 or firstname.lastname@example.org.