Klinefelter: By the Numbers

By Danny Klinefelter
DTN Farm Business Adviser

Given commodity price projections for 2015 crops, grain-based farming faces its toughest year in the last 20. Both farmers and farm lenders need to be vigilant for signs of deteriorating financials, especially if negative returns become a multi-year phenomenon. Taking early corrective action now could mean a much smoother landing than the farm economy experienced in the 1980s.

In 2011, I served on an Economics Research Service panel charged with reviewing the ARMS (Agricultural Resource Management Survey). As part of that process, I contacted 12 senior industry observers and asked their thoughts on leading financial indicators of the future performance of the agricultural sector. Their responses are summarized in 10 bullet points, with the first five presented below. The second five will be presented in a follow-up article. Almost all of the points are applicable to the individual farm and aggregate farm sector level.

Early warning systems have always been important, but as success depends on strategic decision making, it becomes critical. Strategic management is defined as anticipating, adapting to, driving and capitalizing on change. In today’s environment and increasingly in the year ahead, the rate of continuous management improvement needed to remain successful will require improving at the rate set by the leading edge of your competition and not by what fits your comfort zone.

1. Study cycles. Good times never last and neither do the bad. Agriculture is a cyclical business, although it often runs counter to the general economy. It is always important to remember that the function of a competitive market is to drive the economic return to the average producer to economic breakeven through supply and demand responses in both input and output markets. In equilibrium, the top-end producers are profitable and growing, the average are hanging in here, and the bottom end are losing money and being forced to exit the industry. Business success and survival depend on continuous improvement at a pace necessary to stay out of the back of the pack.

2. Use accrual adjusted income, not cash basis to evaluate profitability. Cash basis income is great for simplicity and tax management, but is a poor way to measure the true profitability of a business. The Farm Financial Standards Council has recognized for over 20 years that cash basis income often lags accrual by two to three years in terms of recognizing both downturns and upturns in profitability. That’s often too late to respond. Cash basis income trends to reflect more income smoothing as inventories, receivables, payables, accrued expenses, prepaids, and capital maintenance and replacement are adjusted to even out cash flows and taxable income. Measuring accrual adjusted profitability does not require an accrual accounting system; it simply requires having balance sheets prepared as of the beginning and end of the period for which cash basis income is measured. The balance sheets need to include inventories, accounts receivable, accounts payable, accrued expenses, prepaids and work-in-process. The cash to accrual-adjustment process is simply a matter of arithmetic. Changes in the value of non-current assets (e.g. land) and non-current liabilities are not used in the accrual income adjustment process.

3. Keep your eye on margins. They are more important than absolute commodity and input price levels. For that reason, trends in the operating expense rate or gross margins on an accrual basis are leading indicators. Some analysts track the rate of revenue growth and the rate of growth of operating expenses separately.

4. Remember change can occur quickly, as commodity, real estate, and financial markets make abundantly clear. We have also learned that Black Swan events are real. The tails of economic and financial distributions are larger than the assumptions of a normal distribution. Most risk models capture only "normal" periods, and that includes the rating services such as Moody’s, Dun and Bradstreet, and Standard & Poor’s. This experience has several lessons that need to be heeded in the future:

– Econometric models tend to be data dependent and backward looking. Boards and managers need to rely on judgment and experience and learn to look for leading indicators outside their immediate environment.

– Total enterprise risk management is critical, but implementing it is both expensive and easier said than done. Even the most sophisticated financial institutions are still basically silo risk managers.

– Although linear trends are good indicators of behavior and performance, they seriously understate the potential rate of change created by the external environment, including the impact of technological change. Tipping points often cause exponential rather than linear changes for both upturns and downturns. Timing is critical — for getting in, expanding, cutting back or getting out or redeploying resources. Timing is the main difference that separates the top 10% from the rest of the top 25% of managers and businesses.

5. Watch your change in earned net worth. It is a better indicator of sustainable growth than the change in market value net worth, where earned net worth change is a function of net earnings after taxes and after withdrawals. In the late 1970s and early 1980s, earned net worth for many farmers was declining even though their market value net worth was increasing because land appreciation was outpacing operating losses.

The rate of change, level of volatility and declining government safety nets are increasing the need for farmers to look outside of agriculture and to become more proactive in their planning. Strategic management will become even more important in determining the winners and losers, both during upturns and downturns. One of the most dangerous phrases in business is "because we’ve always done it that way."

The best managers reject the status quo because they know there is always a way to do things better. As Tom Peters said in his book "Thriving on Chaos," if you believe in the saying "if it’s not broke, don’t fix it," then you haven’t looked hard enough.

EDITOR’S NOTE: Danny Klinefelter is a finance professor and economist with Texas AgriLIFE Extension and Texas A&M University where he teaches a beginning farmer program. He also is the founder of the mid-career Texas A&M management course for executive farmers called TEPAP.

(MZT/AG)