Many experts believe our weather is becoming more volatile.
This appears to be borne out by recent weather events and commodity price fluctuations.
A common management principle is to obtain an acceptable return on the investment made in a business.
The definition of investment could be narrow, limited to the capital tied up on land, buildings and equipment. However, there is also the human investment — your time, energy and ideas.
There is another area where investment is made on a farm, but before we discuss at that, I want to take a look at cash flow.
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It doesn’t take long for good or bad weather to affect the cash flow on most farms. Obviously the least desired situation is the cash flow associated with a poor year.
Cash has only four sources:
- sale of assets
- additional debt
- personal contributions
- profit
The first three are not sustainable unless you’ve won millions in the lottery for necessary ongoing personal contributions. A business has to generate sufficient profit from operations to match cash flow requirements.
This cash flow goes to debt repayment, purchase of assets, personal withdrawals and operational expenses.
Adjustments are required when profits are too low to generate enough cash flow to meet expenses.
For example, you might need to adjustment the rate of debt repayment through debt restructuring. You might defer buying assets, and in some cases, personal withdrawals can be reduced.
The latter can be a difficult decision, especially in multi-generational farms where families have different personal needs and financial commitments.
The other adjustment area is in operations, which is related to the earlier discussion about types of return on investment. Money used to pay your variable and fixed expenses is an investment in your farm.
In all situations, but especially where low profit margins hurt cash flow, good management involves analyzing the return made from the investment made in expenses. This is called analyzing the financial efficiency of the business.
A first step in analyzing financial efficiency is to look at a farm’s gross margin efficiency.
Gross margin is calculated by subtracting direct expenses (fertilizer, chemical, seed, crop insurance, feed, veterinary bills) from gross revenue. Dividing the gross margin by gross revenue gives you your gross margin ratio. This ratio is the most accurate indication of your farm’s financial efficiency. For most farms, the industry standard is 65 percent or more.
The question is, from a financial efficiency perspective and especially where cash flow is tight, are you getting the best return possible from the investment you’re making in your direct expenses? Are you near or exceeding 65 percent?
If not, you can look at three areas to improve it: increase yield, increase prices or decrease expenses.
There is a link between financial efficiency and cash flow.
Mike Richardson, a consultant specializing in agile decision making in fast changing circumstances, says that:
- if you don’t like your cash flow in the present, look at your conversations in the past.
- if you want a certain cash flow in the future, focus on your conversations in the present.
Are these “conversations” talking about the right stuff in the right way. They are a function of the things you can look at from a management perspective.
Gross margin efficiency can be managed, and improvements can be achieved over time.
These improvements will result in a better return on the investment made in operations and ultimately work to improve cash flow by decreasing the outflow and increasing the inflow.
