Introduction to Risk Management

Understanding Financial Risk

Financial risk has three basic components: (1) the cost and availability of debt capital, (2) the ability to meet cash-flow needs in a timely manner, and (3) the ability to maintain and grow equity. Cash flows are especially important because of the variety of ongoing farm obligations, such as cash input costs, cash lease payments, tax payments, debt repayment, and family living expenses.

Your objective should be to manage this risk through sound planning and financial control. To do that, you should continually monitor your ability to bear financial risk.

A set of well-maintained financial records is an absolute necessity to maintaining financial control of a farm or ranch. The flow of information is critical in evaluating past performance and in planning for future accomplishments. Financial risk management is not achieved directly by maintaining comprehensive records. However, records do provide much of the information needed to understand critical financial risks.

Essential financial statements include the balance sheet and statement of owner's equity, income statement, and projected and actual cash flows. These records provide a history of your business and the data you need to calculate financial performance measures. Even small farms need a basic level of record keeping.

As the size and complexity of an operation grow, so does the need for financial records. Ratios such as debt-to-asset, debt-to-equity, and turnover are important in monitoring overall financial performance. Other measures can be used to monitor the financial status of the business and provide guidelines for future decisions. These examine liquidity, solvency, profitability, financial efficiency, and repayment capacity of the business.

Investment decisions are based on assumptions about future borrowing costs or the opportunity cost of invested funds. Borrowed capital can be a reasonable expense, especially if you are prudent in the financial leveraging of your business. After all, few operations are in a position to use only equity capital for new investments. Borrowing is a vital part of most farming businesses.

Interest rate risk is mostly out of your control. However, you can sometimes influence your interest rate by lowering your debt-to-asset ratio and through the use of crop insurance coupled with a sound marketing plan. These actions by you reduce a lender's risk exposure.

Ensuring liquidity and adequate cash flow is the same as ensuring the farm's ability to survive shortfalls in net income relative to various cash obligations.

Assets classified as current on the balance sheet are assets that can be converted into cash within one operating cycle of the farm business, usually 12 months. Liquid assets include instruments that yield cash directly or that can be converted quickly to cash. Liquid assets include instruments that yield cash directly or that can be converted quickly to cash. Liquid assets include cash on hand, supplies, and crops and livestock to be sold within the year.

Adequate liquidity is essential to ensure a sufficient cash flow. Also, adequate liquid reserves can facilitate contingency plans for production disasters or poor market conditions. However, excess liquidity typically generates lower rates of return than fixed assets.

Timing is critical for ensuring adequate cash flows. With proper planning of expenses, cash flow needs can be known with reasonable certainty. This allows you to plan marketing decisions in advance and to take advantage of attractive pricing opportunities. Improving liquidity to ensure adequate cash flows can include reducing family living expenditures, using resources efficiently, leasing assets, and using appropriate insurance programs.

There is a lot more to risk management than buying insurance. But, insurance can complement many other risk management tools. Knowing these interactions in risk can help you get more value from your insurance dollar.

An annual insurance review should assure proper coverages and protection. Just because many insurance policies are automatically renewed is no reason to neglect an annual examination of your insurance needs. A healthy "what if" session with your insurance professionals can help identify both weaknesses and opportunities in your coverage.

A significant component of financial risk is controlling and meeting family living costs. Reducing family living costs may not be feasible. But, careful scrutiny of your living costs should be an integral part of annual cash flow planning.

In certain instances, off-farm employment can be a risk management strategy. It can ensure that living costs are met and can increase the family's standard of living. It may also reduce the need to liquidate farm assets to meet family living needs.

Important legal issues are involved in borrowing. The legal language incorporated into loan contracts can be intimidating and puzzling. Nevertheless, you should have sound knowledge of the details and implications of all legal documents. You should seek the guidance of an attorney before you sign important documents.

From a lender's point of view, security and repayment capacity are essential. Liens, credit life insurance, and crop insurance--coupled with a sound marketing plan--can help to make a loan more secure in the eyes of the lender.

From your perspective, you can ensure continued access to debt capital when you need it by maintaining accurate financial records and a consistent record of timely repayment of loans.

It's a Whole New Ball Game
Understanding Goals and Risk Tolerance
Understanding Production Risks
Understanding Marketing Risks
Understanding Financial Risks
Legal Issues Associated With Agriculture
Human Resources Issues