- Managing Financial Risk
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Financial risk covers those risks that threaten the financial health of the farm business. The capital structure
of any business includes both debt (borrowed) and equity (owned) capital. Both debt and equity face risks.
Debt capital can be more risky because of the obligations to others that are part of the financing agreement,
or loan document. Cash flows are part of financial risk and are especially important because of the variety
of ongoing farm obligations, such as cash input costs, cash lease payments, tax payments, debt repayment,
and family living expenses. Record Keeping
A common misconception exists that we only keep records so we can report our taxes. But a successful farm business needs records for many other
purposes too. Some of the most common uses for good records are:
1. Measuring operating and financial performance,
2. Supporting loan applications,
3. Arranging for insurance coverage,
4. Estate planning and valuation,
5. Analyzing investments in depreciable assets,
6. Measuring the profitability of individual enterprises,
7. Monitoring production inventories, and,
8. Developing sound marketing plans.
Balance Sheet
The balance sheet is a financial statement showing financial position at a
moment in time. Assets, liabilities, and owner’s equity (net worth) are the
ingredients that determine financial status. Thus, a balance sheet is a summary of the assets and liabilities of a business, and the owner’s equity, as of a
specific date.
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Although it may be desirable to prepare a balance sheet at various times during the year, it should always be prepared for a farm business on the last day of the accounting period. Preparing a balance sheet on the same date each year makes it easier to compare the financial position over several years.
Most farmers operate on a calendar year basis which means the balance sheet would be prepared around the end of the year in late December or early January.
Assets equal liabilities plus owner equity. This relationship dictates that the value of all assets must equal
the claims on those assets by outside parties and by the owners. Just as the name implies, a balance
sheet must balance. It balances because assets can only be funded by liabilities and/or equity capital.
Income Statement The income statement is the document that correctly measure net farm income. Is is essential to financial analysis, loan documentation, and filing tax returns. It shows how profitable the farm.
Cash Flow
A cash flow statement summarizes all cash inflows and outflows affecting a business during a given period of time such as a month, quarter or year. The length of basis is determined by the flow of cash and how volatile the flow.
Budgeting:
–Helps plan for the useful life of assets.
–Is an excellent device for organizing.
–Is useful when you need credit from lenders.
–Provides detailed estimates of costs, returns, and resources. –Calls attention to inputs and production practices.
–Provides:
-Information for cash flow statement.
-Comparison of alternative enterprises.
-Basis for total farm plan.
Credit Risk
A significant aspect of financial risk deals with credit risk. Credit risk is the risk the lender has that you will borrow money and not be able to repay as
promised and planned. The price of this risk is built into the interest rate of borrowed capital. The higher the risk, the higher the interest rate. To assess the extent of this risk lenders require information from the farm borrower.
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- Depending upon the type of loan, this information usually includes production records, balance sheets and income statements, and, historical and projected cash flow statements. It is the lenders responsibility to impartially analyze this information in a timely fashion and render a decision regarding the risk of extending credit. Both the farmer and the lender have a responsibility to follow sound credit practices. A lender should not extend credit, and a farmer should not accept credit, if there is a high likelihood of non performance and failure. Some credit is simply too risky to accept. Extremely high interest rates should be a signal to a farmer that the institution or individual extending credit views this as a very high risk venture.
