BROADCASTER ARCHIVES

The Capacity Factor in Farm Business Management
By Amber Bennett

This article was printed in the May/June 2010 issue of the Organic Broadcaster, published by the Midwest Organic and Sustainable Education Service.

One of the most challenging and yet most rewarding areas of farm financial management is the analysis of profitability and financial performance, also known as ‘capacity’.  This is where the rubber meets the road, so to speak, in relation to converting resources such as time, labor, capital, and management decisions into a return on investment.  In this article we will explore the third ‘C’ of the ‘Five C’s of Credit’- capacity. Capacity is probably the most important area of financial management.  While agricultural lenders typically analyze numerous ratios and indicators related to capacity, based upon the nature of the farming operation and the credit request at hand, this discussion will focus on capacity decisions as it relates to farm business management from a practical perspective.

1. Hobby or Business- A capacity analysis should be prefaced by an understanding of the motive or purpose of the individual farm business.  If the farm is operating as a full-time business with the purpose of sustaining itself and the owners’ non-farm needs such as family living, insurance, income taxes, and other obligations then capacity analysis is essential to its future success.  Whereas, if the farm’s purpose is to supplement other enterprises or to serve as a pasttime for the owner, then capacity analysis is less essential but still requires a periodic review because most people do not want to unknowingly pour capital into a potentially ‘sinking ship’.  


2. Recordkeeping System- A good recordkeeping system is the first step in determining a farm business’s capacity to generate profit.  In addition, a trusted financial advisor such as an agricultural lender, accountant, or other farm financial expert can be a tremendous resource in this area. Capacity analysis goes well beyond recordkeeping designed solely for income tax preparation at the end of a fiscal year.  It includes numerical comparisons with the capital resource mix and the operational, marketing, and risk-mitigation decisions involved.


3. Resource Allocation & Industry Benchmarks- An understanding of the farm business’s purpose and specialization or diversification strategies is very helpful because this enables the financial manager to accurately calculate, rate, and compare the farm unit’s capacity or financial performance with that of similar operations.   While no one farm business is exactly the same as another, there are similarities within many enterprise types.  This can expedite the analysis and understanding of how a return on investment can be maximized given an optimal blend of resources.


4. Profit Margin per Income Unit- An ‘income unit’ is a term that lenders occasionally use to describe the capital resource or enterprise type involved in a farming operation.  An income unit might be a dairy cow, an acre of corn, a feeder calf, or an apple tree.  The next step is to understand how much profit each income unit is able to generate, such as profit per cow, profit per acre, and so on.  This requires a historical financial analysis of the farm business involved or, at the very least, an understanding of that particular industry’s typical profit margins.  Last, we multiply the number of income units and the profit margin per income unit to determine how much profitability can be expected.   In addition, there are debt threshold guidelines per income unit for many enterprise types to be considered.  Income unit concepts can be very helpful with business start-up decisions or expansion decisions.


5. Beyond Net Farm Income From Operations- A capacity analysis goes beyond just farm income and expenses, it also addresses how much profitability may be needed for a fair return to labor and management, income tax obligations, capital asset replacement or expansion needs, present and future debt repayment, and cash reserves to build liquidity, to maneuver through volatility, and to offer flexibility in future plans for the business.

There are plenty of reasons for a financial manager to be concerned with profitability and overall financial capacity.  Ample financial capacity can provide a farm business with many options for future sustainability, growth, diversification, specialization, and retirement or transfer to the next generation.   A capacity analysis helps one better understand the current financial condition of the farm business and aids in the development of a roadmap for future success. 

Amber Bennett is Vice President- Farm & Home at Badgerland Financial, serving farmers and rural communities in 33 counties of southern Wisconsin. Amber works with a team of lenders who specialize in serving the unique, financial needs of full-time farmers, part-time farmers, and rural homeowners. She grew up on a dairy and livestock farm in southwestern Wisconsin and has 18 years of agricultural lending experience. She received a Bachelor of Science degree in agricultural economics from U.W. Platteville and an MBA from U.W. Whitewater. For more information, check out www.badgerlandfinancial.com.