Financial Risk in Farm Operations

Financial Risk in Farm Operations

Risk and uncertainty are factors that farmers must deal with every day. From ignorance about crop conditions, and prices of inputs and products, to their marketing, and investment decisions, farmers operate based on imperfect information. Such information increases uncertainty and risk and can lead to losses.

Risk can be defined as the potential damage or loss associated with a specific activity or action when the conditions are defined as ideal to guarantee its correct operation or success change. On the other hand, uncertainty refers to imperfect knowledge about a result or the consequences of an action. 

Contrary to uncertainty, the risk is aware of the probability of loss. Something important to highlight is that the greater the uncertainty, the greater the risk. In other words, the less we know about the future, the greater the risk associated with an activity.

There are five main risk areas involved in agricultural activities, which are: Production, marketing, financial, legal and human risk. The interrelation between these types of risk, and their effect on the financial stability of an agricultural operation, make their management a priority. 

To minimise this risk, and ensure the success of the agricultural operation, according to Agriculture Mortgages it is extremely important to establish timely risk management strategies.

Financial risk

Financial risk includes all risks that threaten the financial soundness and stability of the agricultural business. It relates to any financial activity such as covering expenses, lending and borrowing money, drawing on personal savings, or planning investments. 

More formally, financial risk is associated with the management of capital owed (property, vehicles, machinery, etc.), as well as the management of the money used to finance business operations. Said financing can be obtained from own funds (savings), formal institutions (bank loans, mortgages, credit cards), or from unofficial lenders such as family loans, cooperatives, etc.

Financial risk management contributes to the sustainability and financial soundness of the agricultural business. For this, it is important to also consider the time factor. Depending on the period defined for the analysis, the risk associated with an activity may vary depending on the financial obligations in the short, medium or long term.

Components of financial risk

  • The main components of financial risk are:
  • The cost and availability of capital
  • The ability to meet cash needs and cover obligations in a timely manner
  • The ability to absorb short-term financial shocks
  • The ability to maintain and increase the assets of the business.

Agricultural businesses can finance their activities through contributions from partners or their own capital, or by making use of the money of others, that is, through debt. The cost and availability of capital is an important consideration when considering financing options. 

One way to think about the cost of capital is through interest rates. In the case of availability, lenders evaluate the financial position of a business through its liquidity, solvency and ability to pay.

The second component, the ability to meet cash needs and cover obligations on a timely basis, indicates the ability of the agricultural business to pay its obligations using the income obtained from its assets if these were sold. This is what is known as liquidity. The current ratio and working capital are good indicators to measure liquidity.

The third component is the ability to absorb short-term financial shocks. It refers to the operating cash (assets – liabilities) available to absorb shocks that may arise unexpectedly.

Finally, the ability to maintain and increase the business’s equity indicates the ability of the agricultural company to maintain its performance in the long term. It takes into account the operational efficiency of the business, that is, its ability to maximise its profitability, making use of its assets.

Risk management and financial statements

Efficient financial risk management relies on the establishment of an information system that allows evaluation of the past and current performance of the business while allowing planning for the future. This system is made up of four financial statements: The balance sheet, the income statement, the cash flow, and the statement of changes in net worth.

The balance sheet provides information about current and noncurrent assets and liabilities, and about the net worth of the business, for a specific accounting period. It offers a look at the financial position of the farm, allowing the cost and availability of capital financing to be determined. 

It also provides information about the liquidity, working capital, solvency, and net worth of the agricultural business, which are key points when considering financing options.

The income statement or statement of profit and loss, on the other hand, uses the general balance sheets at the start and end of the period to show the net income of an operation during a given accounting period. It’s a key statement for profitability metrics, including the rate of return on assets, and operating cost-profit margin.

The third statement, the statement of cash flows, records the cash movements made in an operation. Indicates where and when cash was generated from the sale of products, inventory, or assets. In the same way, it records transactions related to the payment of debts, interest, inputs, family expenses and any purchase of assets or investments. This state allows you to verify if the business obligations are met on time and if there is enough cash to cover short-term obligations without having to liquidate any assets.

The statement of changes in net worth measures the progress and financial growth of an operation. It provides information that allows evaluating the actions and activities carried out during the accounting period, and whether they have added or subtracted value to the agricultural business.

The establishment of financial records is essential to analyse the performance and financial health of the business while helping to reduce financial risk. Through these records, a farmer is able to assess the liquidity, solvency, growth and profitability of his business. In the same way, they allow well-founded decisions to be made about investments, credit options, business vision, and changes in operations to improve performance.

Tools for financial risk management

In addition to establishing a good financial reporting system, there are some useful tools for managing or minimising financial risk. It is important to mention that financial risk management is specific to each operation, so the application and effectiveness of these tools depend on the individual situation of the agricultural business.

Keep reserves- The maintenance of reserves such as cash, and assets easily convertible to cash (e.g. accounts receivable, inventories, etc.) can help to face short-term financial impacts, allowing business operations to continue. 

Net worth-  Farmers can finance their activities through debt or with their own capital. It is important to know the debt-equity ratio in order to improve decision-making on financing. 

Interest rates and credit reserves-  When agricultural activities are financed by lenders, farmers can make use of interest rates and credit reserves to minimise financial risk. Farmers can refrain from borrowing the maximum amount offered by a borrower, in this way, such funds can be requested in case any activity leads to losses.

Rent/Lease- It is known that agriculture is capital-intensive. Investments are usually required in land, machinery, and infrastructure, among others. When you do not have enough capital, and you want to avoid the risks associated with a loan, renting or leasing is a great option. 

The previous tools are associated with financial decisions, however, there are others that allow alleviating or mitigating said risk, such as:

Employment unrelated to the agricultural business-  It is important to have an additional source of income, and not linked to business activities. This, with the aim of helping farmers and their families to manage losses, and cover family subsistence expenses. 

Management of other types of risk- Financial risk may be increased by production or marketing activities. The level of production and market prices determine the income from sales and the expenses of the company. 

Proper financial risk management is the key to success of an agricultural business. A well-established financial information system, complemented with some of the exposed tools, can help not only reduce risk exposure but also can contribute to making critical decisions necessary for the well-being, sustainability, longevity and success of farm operations.

Robin Williams

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