I received a question recently during a webcast for dairy industry professionals: With DRP, DMC, MPP and traditional milk marketing tools such as puts and calls, what is a realistic way to decide where to spend money on risk management?
While this question is dairy oriented, other sectors of agriculture, such as crop and other livestock, face similar challenges in allocating dollars for risk management. The specific answer to this question would be different for each business; however, there are some general considerations when analyzing how much money one should spend and how it should be allocated among different risk management options. The following suggestions are in no particular order and must be customized to the specific business.
Consider debt levels and debt servicing obligations. How much are debt service obligations per hundredweight of milk, bushel of grain or pound of meat? Higher levels of debt require more risk management backup, so the allocation of dollars to protect cash flow is important.
When developing a risk management program specific for a farm business, knowing the cost of production by enterprise is critical. How much does the risk management program add to the cost of production? One can conduct a cost-benefit analysis with a spreadsheet or financial program for each of the enterprises, and from a global or overall business standpoint.
Examine working capital on the balance sheet. The higher the level of working capital, the more risk-bearing ability the business has. Working capital to expenses above 33% is a good goal. Working capital to expenses below 10% with considerable debt servicing requirements and high price or cost volatility would suggest a strong look at the risk management program within the cash flow context.
A higher amount of equity, such as percent equity or owned assets above 70%, provides a cushion for adversity. With this level of equity, a farm business could be in a position to restructure or refinance debt if considerable land assets exist. This could “buy time” in case of weather or marketplace adversity. A simple spreadsheet with various options on cash flow with price, cost and risk management cost can provide road markers to keep the business out of the ditch. In a mature operation with considerable equity, a risk management program must be evaluated from a wealth preservation standpoint. You do not want losses to burn through your equity or the working capital you may have built up.
Finally, can you sleep at night and feel comfortable with your risk management strategy? If not, your strategy may go against your internal compass. Sometimes talking with a good advisor to discuss your thoughts and strategies can bring peace of mind. While this response is generic, and I am not a marketing expert, thinking through these points and perspectives can provide direction, as well as help avoid any unintended consequences.
Dr. Kohl is Professor Emeritus of Agricultural Finance and Small Business Management and Entrepreneurship in the Department of Agricultural and Applied Economics at Virginia Polytechnic Institute and State University. Dr. Kohl has traveled over 8 million miles throughout his professional career and has conducted more than 6,000 workshops and seminars for agricultural groups such as bankers, Farm Credit, FSA, and regulators, as well as producer and agribusiness groups. He has published four books and over 1,300 articles on financial and business-related topics in journals, extension, and other popular publications.