Crunch the numbers before you invest, expand, diversify
- The best time to launch an idea is when things are going good
- Complete a financial projection before planning a major investment
- Knowing your operating expense ratio is important when deciding to invest
Expansion, investing in new equipment or services, or diversifying by adding a value-added business can provide a great boost to a farm’s bottom line. However, they could also threaten a farm’s viability if the farm isn’t in top financial health.
People rarely think about adding a value-added venture when things are going well. But that’s the best time to launch a good idea, as nearly every new business will take twice as long and cost twice as much as expected to get off the ground.
A business has to be able to make ongoing investments in machinery and equipment purchases as needed.
“A business has to be able to make ongoing investments in machinery and equipment purchases as needed,” says Roger Mills, a farm management consultant based in Steinbach, Man. “However, if they’re planning a major investment for things like quota purchase, new facilities, land purchases or even a diversification project, then I would advise producers to ask their advisor or consultant to complete a financial projection to see if the proposed idea actually cash flows.”
Financial projection will help
First, this gives you the numbers to determine if you’re making a wise investment. Second, your lender will appreciate that you’ve taken the time to back up your proposal with research before you take on further debt. Mills says producers should never devote more than 30 per cent of gross revenue – and ideally less than 28 per cent – for debt servicing.
One common misconception is that expansion to capture savings through economies of scale will always help your bottom line. While these do exist in agriculture, they are greatly overrated at the levels of expansion most people are considering, says Brent Gloy, a visiting professor at Purdue University in Lafayette, Indiana, and contributor at AgEconomists.com.
A 10 per cent increase in acreage won’t offer much improvement in your cost structure, and if you don’t already have a low cost structure for the size of your operation, expansion will probably make things worse.
Operating expense ratio
Calculating your farm’s operating expense ratio (OER) can be a valuable tool for deciding if it’s a good time to invest. An OER is a relatively simple number to come up with, if you accurately know your actual costs: divide total expenses by gross revenue.
“Really efficient producers’ OERs could be as low as 50 per cent,” Mills says. “Operations in this range are quite profitable. However, I’m finding it’s becoming more difficult for the average producer to keep their OER at 60 per cent or less. If they keep salaries and personal withdrawals in the 12 per cent range, a 60 per cent OER only leaves 28 per cent for debt repayment.” Such an operation is only breaking even, and isn’t generating a profit.