By Dr. David Kohl
This article was inspired by the work the Federal Reserve has done to stress test banking institutions with various recession scenarios. As a proactive manager, it is important to think through business practices and financial stress testing scenarios to anticipate outcomes if an agricultural recession were to occur. Let’s examine a few scenarios and determine how your business stacks up.
Financial liquidity
Whether it is a household, business, financial institution, or a country, the first financial stress point is usually the lack of financial liquidity. Adequate financial liquidity is the ability to meet needs and obligations without disrupting normal operations and activities. To achieve this, one needs working capital divided into total expenses or revenue of 20 percent or greater. Working capital is defined as current assets minus current liabilities. Others will use the current ratio which is current assets divided by current liabilities. A current ratio of 1.50 to 1 is usually sufficient. This means for every $1.50 of current assets there is $1.00 of current liabilities. The timing of the sale of current assets and the ability to collect accounts receivable compared to the payment of current obligations needs to be considered along with the quality of current assets.
Cash
In this analysis, the quickness to cash or the ability to generate cash from current assets without hindering the sale negotiations needs to be considered. While cash is an asset, very few businesses and households maintain adequate cash reserves. It will be more important in a highly volatile environment with uncertain prices and costs and higher interest rates. Cash is the asset of choice as a final shock absorber and to position for opportunities.
Marketing and risk management
A well-planned, executed, and monitored marketing and risk management plan is critical in a business financial stress test. With a wide variation in both upside and downside price and expense risks, the basics of cost of production and breakeven analysis are practices to mitigate risk and capitalize on opportunities.
Does your business employ a set of financial spreadsheets with various production, pricing, and cost scenarios? Stress testing reveals the boundaries or the guardrails of possible outcomes and can provide more objectivity rather than emotionalism in key short and long run decisions. The key is to have various programs including insurance products, hedging, and options that are customized and most appropriate to your business situation.
Enterprise analysis
Many agricultural business operations have multiple enterprises as a means of diversifying risk. A good set of enterprise budgets with different financial scenarios and break even points can be useful in a stress test. This is where knowing your land, equipment, and livestock resources and being able to allocate them for both short and long run sustainability is crucial. In your analysis, stress tests concerning resiliency, agility, and nimbleness are three keywords in the business IQ vocabulary.
Trusted advisors
A popular trend in agriculture, particularly amongst young and beginning producers, is forming advisory teams. These teams can include individuals such as a crop or livestock consultant, a lender, or marketing and risk management provider. When needed, an accountant, financial advisor, or lawyer can become part of the team. More progressive producers are utilizing mentors and peers to provide guidance on strategy and decision-making. In our dairy creamery business, counsel from outside the industry to provide another set of eyes has been an invaluable resource. These advisory team meetings are often quarterly and can be face-to-face or virtual meetings. Advisory teams can assist in different financial and business decisions, but they are also available for emotional support.
Weathering cycles
Weather risk, geopolitical risk, and consumer societal trend cycles are inevitable. There is an art and a science to applying business and financial strategies and actions and then connecting the dots and the gut feeling. Remember, some of the worst decisions are made during the best of times and some of the best decisions are made during the worst of times. Stress testing business practices and financial scenarios is a proactive method for soundness of business and mind as well.
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 10 million miles in his career and conducted over 7,000 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.
