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And Then There Was Profit

By Paul Kuntz

Holy smokes, the 2021 growing season is looking to be a great one for western Canadian farmers. Seemingly out of nowhere, grain prices for new crop have taken off.

We have all experienced old crop price runs. Every now and then we see a commodity price rally because supply is low. It happens in small acreage crops like yellow mustard and canary seed quite often. It normally does not happen in the large acre crops because the users have a reasonably good idea what is out there for crop and they act accordingly. 

A new crop rally is a whole different ball game. Typically, a fresh harvest is a chance for merchants to steal some grain from farmers forced to sell. Paying a farmer a premium for their crop when it is the most convenient time to deliver, is rare.

Managing the financial aspect of your farm when grain prices are high is not really a problem, but it does have its challenges. Also, it might create opportunities to make changes that will pay dividends for years to come.

The first financial management tip is do not spend it before you have it. As farmers, we already risk a lot of dollars in the spring in hope of a crop. Do not count on this price windfall to expand long-term debt or any decision that will increase annual cash outflow. We do not have this crop in the bin yet, and we cannot expect these prices over the long-term.

The next financial management tip is to manage the income tax. If you are carrying in inventory into 2021, and if you need a lot of cash in the fall, speak with your accountant. If you need the money for direct writeoffs such as fertilizer or chemical, that may not be an issue. But if you need a big chunk of cash to pay off a cash advance or term operating, there could be trouble. You may end up with too much income in one year. There are many ways to correct this, but you need to plan for it.

I like to look at opportunities like this to make a long-term positive financial difference to your farm. The very first thing you need to do if your farm makes extra profit this year is to improve your working capital. Almost every farm I deal with struggles with working capital. We like to spend money, and that is great, but sometimes we need to hold a portion back. Working capital is one those financial parameters that is all over the map with farmers. It depends on how long you have been farming, how good/bad the past five years been financially, and how well structured was your farm was when you started. It also has a lot to do with how much you spend beyond crop inputs.

Certain farms need operating credit to buy 100 per cent of their inputs for the upcoming year. Others only need a bit of credit to get the crop seeded. Some farms have all of their fertilizer, chemical and seed paid for before they start seeding. Depending on where you are on that spectrum, you can find ways to improve your working capital with extra profit.

The great thing about taking a crop price windfall and improving your working capital is that it can have a lasting effect on the farm for years to come. If the next few years turn out to be average income years, or even a bit below, your farm will still be better off. Your farm will also see opportunities to buy inputs in the off season. You will also notice an air of confidence in your decision-making both in agronomy and marketing. 

If you want a measurement of a healthy working capital, there is an equation for that. Your farm should have enough working capital to cover 50 per cent of your projected upcoming annual expenses. Your working capital is your calculated by subtracting your current liabilities from your current assets (do this at year-end). Then compare that number to what your farm spends each year. You want to get as close to 50 per cent as you can. That is a healthy working capital.

Alternatively, instead of improving your working capital, you could use extra profit as down payments to get newer equipment and bins. It will feel good for a while but in a couple years when income goes back down, those extra payments are going to bite. 

If your farm is replacing equipment or buying bins, that is not necessarily bad. These are necessary items for a grain farm. You just need to ensure that your farm can operate with more traditional grain prices.

Often when we think about getting extra profit, we think of paying down debt. Although this can seem like a great place for the money, you need to be careful of this. First off is the income tax implications of this. You are taking taxable income and using it to pay non-taxable principle. This could create a large tax bill. Another reason this move needs additional consideration is the rate of interest we are currently paying. Most likely you are experiencing lower borrowing rates on your farm. Your rate of interest on a loan is the rate of return you are getting when you put extra cash on it. For example, suppose you have a land mortgage that you pay 3.85 per cent on right now; if you take $50,000 and put that on your mortgage as a pre-payment, you will earn a 3.85 per cent rate of return on that cash. The same goes if you have a five per cent interest rate on some equipment. As entrepreneurs, you will earn a lot higher rate of return of you invest that cash into your operation. There always come a time and place when you can pay down debt, but it will be towards the end of your farming career and not the beginning. 

If this growing season produces good yields and above-average prices, be sure to treat the windfall as just that, a one-off event. Although rising markets often set a new higher bottom for that commodity, we must have expenditures that are within the means of the farm’s average income. If you happen to knock one out of the park financially, be sure to do something special with that success that pays dividends for years to come. Here’s hoping for an exceptional year.