By Dr. David Kohl
A common question from producers who are engaged in my farm seminars is, “How do I balance business growth with risk?” One may question why producers are considering growth during a down agriculture economic cycle. As I crisscross the country, I have found that 30 to 40 percent of businesses are in a selective growth mode. This decision is being made in an environment with razor thin margins and extremes in economic and financial volatility.
First, in balancing growth with risk, execution of the business plan is critical. This requires key stakeholders to identify their vision and business, family, and personal goals in writing. One- and five-year objectives with quantitative measurements are preferred.
Once the goals are established, one must consider whether the growth or expansion is consistent with existing land, labor, capital, and information resources. Will an expansion lower the cost of production by spreading fixed costs over more production units? Will the expansion require additional capital investments in land, equipment, and/or livestock? A rule of thumb is to overestimate both the time and money required for an expansion by at least 25 percent when developing projections to account for unforeseen issues.
Underestimating the amount of capital that needs to be borrowed is a critical mistake made in some expansion projects. If the correct amount of funds is not borrowed, the capital expenditures are funded through liquidity reserves or cash flow, which often results in cash flow and working capital issues 12 to 24 months later.
The balancing act of growth and risk includes an internal assessment of management capability. I have developed 15 critical management characteristics that represent business IQ. These traits include knowing the cost of production, developing and executing a marketing plan, and developing and monitoring a cash flow. Growth, without management horsepower, often results in system failures and profitability issues down the road.
In some cases, the existing management team must allow the possibility of new players to bring their ideas to elevate the business to the next level. This is one of the biggest challenges of family business transitions.
There are a few key financial metrics that a business can evaluate to provide a pathway to balance growth and risk during an expansion.
- If the business is in a growth mode, the adequacy of working capital must be evaluated. Working capital is a measure of liquidity, calculated using current assets minus current liabilities. Before expansion, the ratio of working capital to expenses should be at least 30 percent or greater to provide flexibility in case of macroeconomic issues or possible trade issues. This working capital reserve may be necessary if there is a failure in management, production, or marketing plans. Post expansion, this metric must be at least 15 percent of expenses.
- One of my favorite ratios is term debt to EBITDA; this ratio is calculated using all term debt divided by EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization are deducted. If the term debt to EBITDA ratio is greater than 6:1 post expansion, then the growth may be placing your business in a risky position if any adversity were to occur over the long term.
- Monitor the debt to asset ratio. If this ratio exceeds 50 to 60 percent, counter strategies must be implemented. Stellar production with reasonable costs resulting in good financial strategies will be critical. Good cost control metrics, along with modest family living, will also be important.
Finally, in all the growth and expansion situations a team approach is a best management practice. Working side-by-side with your lender and crop or livestock consultant can provide the expertise to navigate the economic white waters that can lead your business to a positive destination.
Dr. David Kohl energizes agricultural lenders, producers and business professionals with his keen insight into the agricultural industry through extensive travel, research, and networking around the globe. He is a Professor Emeritus of Agricultural Finance and Small Business Management and Entrepreneurship at Virginia Tech, Blacksburg, VA. Dr. Kohl has traveled over 8 million miles in his career and conducted over 6,000 workshops and seminars for a variety of agricultural audiences. Additionally, Dr. Kohl’s personal involvement with agriculture provides a unique perspective into the future trends of the agricultural industry and economy.
