Farmers who want to make money in today's unpredictable economy would do well to assume a corporate mindset and think like a chief financial officer, a Purdue University agricultural economist says.
With many farm businesses now multi-million-dollar operations and the operating risk in agriculture increasing, producers should focus more time on the financial side of their business, said Mike Boehlje. CFOs think about profitability, capital structure and debt service, size and growth, risk and financial documentation, and creating shareholder value, he said.
CFO-type thinking will help farmers navigate swings in commodity prices and production costs. Although price volatility is inherent to farming, price fluctuations are greater today than they were in the past.
"Now we also have cost volatility, which means that we've got three to four times the volatility in margins that farmers are facing today compared to what they had, say, five or 10 years ago," Boehlje said. "When you have more operating margin volatility that just puts more risk in the business."
To better manage those risks and turn a profit, producers need to understand the three drivers of profitability in any business: margins, asset utilization and financing, Boehlje said.
"We spend a lot of time on margins and thinking about whether our revenues exceed our costs, what our margins are per bushel of corn or per hundredweight of hogs or whatever it might be," he said.
"Asset utilization, or what we call asset turnover, is the number of sales per dollar of assets that we generate. So, even if I don't have the kind of margin that I'd like or have a little bit lower margin on sales, if I've got a lot of sales per dollar of assets I still can have a reasonably profitable business because I'm generating a lot of throughput through my operation based on my asset base."
How farmers finance their business — the third profitability driver — is especially important because it determines the cost they're paying for borrowed money.
When considering capital structure and debt service, CFO-minded farmers must determine if they have the ability to repay loans and other debts based on their profit margins, market volatility and interest rates, Boehlje said. In some cases, farmers might have to finance the growth of their business with more of their own money rather than relying on a lender.
Consider skill set
A CFO approaches size and growth of a business from more than just a capital position, Boehlje said. "The CFO also worries about his managerial skill set. For a farmer that might mean, 'Who is going to run this new dairy operation?' 'Do I have the operational managerial capacity?' So they have to continually focus on the right way to grow, as well as make sure the resource base is there to grow successfully."
Thirty years ago a chief financial officer's job was almost exclusively devoted to financial documentation. No more, Boehlje said. Today, the bookkeeping is often done by someone else, allowing the CFO to focus on understanding what the financial numbers mean and how they can be used to improve business performance. In agriculture that can translate into an added emphasis on insurance coverage, financial planning, accounting systems, cost control, profit planning and auditing, he said.
To the farmer, creating shareholder value is all about adding value to the operation. That includes the farmer's time and "intellectual capital."
"We can be profitable according to our tax return or according to our income statement, but unless we're generating enough income and revenue to reward ourselves for our contributions that we are making to the business, we may not have created value," Boehlje said. "I ought to at least mentally write myself a check for the return I expect to get on my money. I've got to get paid for my time, I've got to get paid for my intellectual and managerial capacity, and I've got to get paid for my money, as well. And it's only after I take those expenses into account have I really figured out whether I have created value."
A good resource for thinking like a CFO is the DuPont Financial Analysis Model, a software program that calculates a business' profitability based on operating profit margin, asset turnover ratio, return on assets and return on equity. Farmers need only a simple set of business numbers to do the calculations, Boehlje said.
For additional information on the CFO approach to farming, visit the Purdue Strategic Business Planning for Commercial Producers Web site at http://www.agecon.purdue.edu/extension/sbpcp/finmgmt.asp and click on the "Thinking Like a CFO" link. The DuPont model is available at the "Improving Performance" link.