If you’re intimidated by the thought of using a computer, you’ll find that often the place you buy it from (or the person you buy from if it’s used) will help you get started. If not, go to an adult education class, get the kids to help at first, or find a friend or neighbor who is familiar with computers. They really are quite user friendly once you get the basics down.
Calculations
There are lots of equations and calculations in the planning chapters. They all use basic math — nothing too fancy, but in case your math skills have gotten a little rusty, remember the following rules:
Work that appears inside of (parentheses) should be done first.
Example:
(2 + 3) x 4 = 5 x 4 = 20
When rounding a decimal to a whole number, the number 5 or greater is rounded up; anything below 5 is rounded down.
Example:
8.5 rounds to 9, when rounded to the nearest whole number
Example:
3.43 rounds to 3, when rounded to the nearest whole number
So that you can find the numbers easily when you want to work with them later, all the calculations used in part IV are listed in appendix F.
CHAPTER 13
Financial Planning
North American livestock producers are the most productive in the world. We are also the least profitable.
— David Pratt, “Farm Advisor” (Livestock & Range Report No. 961, University of California Cooperative Extension, Summer 1996)
Renting farm property has several outstanding advantages, among which perhaps most important are:
1. No capital need be invested in permanent features.
2. Such capital as the tenant does invest may all be for machines, tools, animals, portable houses and other “loose” property which he can take with him. . . .
— M. G. Kains, Five Acres and Independence (1935)
No unemployment insurance can be compared to an alliance between man and a plot of land.
— Henry Ford
HUMAN NATURE IS A STRANGE THING: No matter how much money most people (or businesses) make, their expenses climb to near or above that amount. This is part of why many high-salaried individuals file for bankruptcy despite big incomes. Financial planning should help you overcome this tendency, but keep in mind that traditional economic theories and traditional financial planning supported the very decisions that drove many farmers off their land over the past 50 years and left us with polluted water, polluted air, and erosion. This is because traditional financial planning looks at the bottom line as sacrosanct. Your financial plan, on the other hand, must look at finances in a broader sense, and should include not only paper money but also quality-of-life, social, and environmental aspects of your decisions. It isn’t simply about record-keeping, accounting, or budgeting; it is about planning for income, planning for profit, and prioritizing expenses.
Balance Sheets
Assets are the economic resources that a business has available to it, and that are expected to provide some future benefit. In the case of a farm, land, buildings, equipment, livestock, and money in the bank are all types of assets. Liabilities are the debts of the business and may include mortgages, loans, and amounts of money owed to suppliers or employees. Equity is theoretically what the owner has already put into the business, or the difference between assets and liabilities.
Let’s say you own a farm that is valued at $100,000 under current market conditions, and that you have a mortgage for $80,000 against it. This leaves you with $20,000 worth of equity. If land values go up, your equity increases, but if they drop so does your equity.
The balance sheet is an accounting form that lists all the assets on one side, the liabilities and equity on the other. The two sides must balance (Table 13.1). Now, if you study the balance sheets for the example farms, your first reaction will probably be that the Blacks are rich, but remember — assets, particularly land, are only of value when disposed of. This is what’s known in agriculture as being land rich, cash poor. The Blacks have more than $1.5 million of equity, but the Joneses, the Millers, and the Wilsons all have more cash and other investments.
Each of our example farmers does have some owner’s equity, which means that if they sold out, there would be some money left over after paying all the bills, but this isn’t always the case in agriculture. Many, many farmers are stuck in the unenviable position of having negative equity: If they sell out, they still owe the bank money.
Table 13.1
BALANCE SHEETS FOR EXAMPLE FARMS
Land
Land is a unique piece of the agricultural pie. It is, of course, one of the main ingredients of a farm, yet it very rarely pays for itself in farm-generated cash flow. This paradox is the result of land’s unusual role in the economic landscape.
Land Is a Nondepreciable Asset
Depreciation is the “costing out” of an asset over its “useful life,” but unlike most other assets land’s useful life is in perpetuity. Let’s look at an example: You purchase a new pickup truck; it has a useful life of seven years. Each year that you own the truck, the Internal Revenue Service will allow you to deduct one-seventh of the truck’s value from your income for tax purposes. This is depreciating the asset, and it is allowed because the IRS figures that at the end of seven years, your truck isn’t going to be worth much of anything anymore. On a farm you can depreciate buildings, breeding stock, machinery, equipment, office machines, and vehicles. But land, in theory, retains its useful value indefinitely; so land can’t be depreciated.
Land Appreciates Over Long Periods of Time
Land distinguishes itself from other assets not only because it retains its usefulness, but because it generally appreciates (or adds value) over long periods of time. During certain economic periods, the value of land can increase very dramatically (high inflation), though most often the increase is slow. Then there are some periods when land will lose some of its value (deflation). But if you purchase a piece of land and hold on to it for 30 years, the odds are it will be worth quite a bit more than what you originally paid for it. The appreciation of land value is generally caused by one of two things: anticipation of future profits or nonagricultural pressures.
Anticipation of Future Profits. The anticipation of future profits can drive prices up from year to year and, at times, cause spiraling inflationary and deflationary cycles with respect to land value, much like a self-fulfilling prophecy. This happened in the go-go days of the late 1970s and early 1980s. Prices began climbing, so farmers (and investors) thought, “If my land is worth X amount of dollars today, it will be worth X-plus tomorrow. If I buy more land, it too will increase in value.” Unfortunately, what many farmers and investors found was that when the peak was reached, the prices fell just as dramatically as they had previously risen, and farmland prices in the late 1980s were at the bottom of the barrel. Many farmers, investors, and small banks lost everything as a result. Our Minnesota farm was a prime example: An investor purchased it in 1983 for $48,000; we bought it 6 years later for $30,000. The investor — who purchased numerous farms in the area during 1983 and 1984 — declared bankruptcy.
Nonagricultural Pressures. Nonagricultural pressures that may drive up prices include recreation, tourism, and development. Depending on where you live in the country, these pressures may drive prices completely off the scale. Nonagricultural pressures came to bear on central Minnesota farmland during the late 1990s. City people were purchasing farms in our area for hunting places or weekend retreats, almost doubling land values in the area over a year or two.
Impact on Farmers and Farms
Land’s nondepreciable nature has a large impact on farmers and farms. In real economic terms, owned land is generally a drain on the wealth of a farmer; rented land is generally a boon. Land is a good long-term investment if you can afford to purchase it with after-tax income (profits), but if you don’t have true after-tax income available, then renting is the better option. Rents are fully tax deductible from
farm-generated income, and even if land prices are pressured by outside forces, rents remain based on agricultural operating income potential. Most often, the best approach is to blend a small deeded holding with rental lands. (Notice how many of the farmers and ranchers that are highlighted throughout this book rent at least part of the land they are using.)
The Balance Sheet. Develop your own balance sheet, but perform two different sets of calculations. The first set should be based on current values of all assets; the second should be based on the lowest value of assets in the most recent economic cycle. For example, if land is currently selling near you for $1,200 per acre ($2,965 per ha), use that figure to calculate your current situation. Now, think back to what the worst prices were for similar land in recent history; if it sold for $700 per acre ($1,730 per ha) 10 years ago, calculate that situation — it gives you a worst-case scenario. If you do have to borrow money against land, never, never borrow more than the low value of the land. And when the cost of land is spiraling upward, beware. Hoard your money for the next time that the low price and the current price happen to be about the same — that’s the time to buy. These are the times when the popular media, like local newspapers, are bemoaning the fact that “you can’t give real estate away!”
Opportunity Cost
When you own an asset, there is always an opportunity cost on your capital. Opportunity cost is the amount of money you could earn with the money that is currently tied up in an asset if it were invested somewhere else. One of the safest long-term investments available in the world is U.S. 30-year Treasury Bonds, so these are a good benchmark for safe earnings, or a minimum return on investment.
The Wilsons have equity of $129,100. Subtracting the cash in the bank and stocks from their equity (because these should be earning a return) gives a farm-invested equity of $124,600. If this were invested in a T-Bond (currently paying about 5%), it would earn them about $6,200 in a year. This is their opportunity cost, and their operation should pay them at least this much above operating expenses each year. The Blacks’ opportunity cost is $76,000 [(1,522,310 1,200) 0.05]; the Millers’ is $7,200 [(160,450 16,500) 0.05]; and the Joneses’ is $15,200 [(314,000 10,000) 0.05].
In reality, when you invest in a business you have a greater risk than when investing in a T-Bond, so you should consequently aim for a higher return on your investment. Businesses typically seek to double the T-Bond rate or, in today’s market, make a 10 percent return on their investment.
From the current farm equity that you calculated on your balance sheet, calculate the opportunity cost based on the T-Bond rate, then double this. If you look at this number and say, “Wow, there’s no way I’m making this kind of return on my investment,” don’t feel bad. Few farmers do. However, you now have an amount to begin aiming for in your financial planning.
Zero-Based Budgeting
In the early 1980s, I was hired to manage a sanitation district in Frisco, Colorado. A sanitation district is a unit of government whose primary responsibility is operating wastewater treatment plants. I had worked up through various wastewater plants over the previous decade, so I was qualified as far as operations, maintenance, and laboratory work were concerned, but I had no real experience in the business-administration end of things — like preparing a budget.
Even though I was inexperienced in such matters, I knew that the district’s previous budgeting process could use a little improvement. I called up the local certified public accountant who had done the district’s audits (a legal requirement for all public entities in Colorado) and offered to buy him lunch if he’d let me pick his brain on how to go about improving the budget process. Pat was enthusiastic about my request: He’d been recommending better budgeting to the elected board of directors for several years.
With his guidance, I developed more detailed accounts; for example, instead of one line item for maintenance-related expenses, I broke out several different maintenance categories. In the case of a farm, your line items should be broken down so that you can track various enterprises or operations. Instead of one large category for “feed,” break it down into feed categories for each class of animals being raised. Instead of one income line for “farm products,” break it down into “cull cow sales,” “cull sheep sales,” “steer sales,” “lamb sales,” “beef sales (meat),” “lamb sales (meat).”
The next recommendation Pat made was to “budget income conservatively low, and expenses conservatively high” — and to do it with a technique known as zero-based budgeting. When budgeting conservatively low for income, you have to factor in such things as a higher-than-normal death loss, or lower prices. For budgeting conservatively high expenses, think about things like price increases. But the word conservative in both categories means stay reasonable — if feeder pigs are currently selling for $45, the 10-year high was $60, and the ten-year low was $20, then $30 is probably a conservative figure for budgeting income.
In zero-based budgeting, you begin each year as if you have no previous experience — or no known amount of income or expenses from previous years. You have to think about each item you will need, investigate prices, and develop the budget based on those numbers. Typically, most people budget — if they do it at all — by saying, “Last year I spent X number of dollars on something, so this year I’ll probably spend X plus a little more.” And, by God, that’s what they end up spending — or even more than this. Zero-based budgeting takes more time and a good deal more thought, but it provides a superior product when you’re done.
In a traditional budgeting paradigm, the Blacks might say, “Last year we spent $4,000 on fuel for trucks and autos, so this year we’ll figure that we’re going to need $4,500.” This year, instead, the Blacks are going to sit down with pencil and paper and do some figuring (Table 13.2).
During our lunch discussion, Pat reminded me that this is a mental exercise in “best guessing” and, as he pointed out, even your best guesses can be wrong. His recommendation was that after you’ve developed your expense figures, add 5 percent for a cushion.
Table 13.2
GASOLINE WORKSHEET FOR THE BLACKS
Gas for Miles’s Pickup
2 town trips per week at 30 miles =
60 miles × 52 weeks = 3,120 miles
Ranch miles = 50 per week × 52 weeks = 2,600
2 city trips per month at 220 miles =
440 × 12 months = 5,280 miles
Total Miles’s pickup = 11,000/12 mpg $1.10/gal =
$1,008.33
Gas for Mark’s Pickup
1 town trip per week at 30 miles =
30 52 = 1,560 miles
1 city trip per month at 220 miles =
220 × 12 months = 2,640 miles
Total for Mark’s Pickup = 4,200/10 mpg × $1.10/gal =
$462.00
Gas for Cars
2 town trips per week at 30 miles =
60 miles × 52 weeks = 3,120 miles
vacations and long road trips = 5,000 miles
Total for cars = 8,120/14 mpg × $1.10/gal = $638.00
Diesel for Stock Truck
20 trips to sale barn at 120 miles = 2,400 miles
20 trips from ranch to allotment at 30 miles =
600 miles
Total = 3,000/12 × mpg × $1.20/gal = $300.00
Miscellaneous Gas and Diesel
$500.00
Total:$1,008.33 + 462.00 + 638.00 + 300.00 + 500.00 =
$2,908.33 × 1.05 =
$3,053.75
The family members all agree they should be able to live within this budget for gas, which knocks almost $1,000 off what they spent the previous year. They see that this allows for plenty of town and city trips, but they will make a conscientious effort to keep their use within these numbers.
Cost of Production
There are two types of costs that all businesses incur in producing their product: fixed and variable. Fixed costs are those that must be paid regardless of what volume or type of production occurs and gener
ally include things such as mortgages, long-term loans, insurance, full-time labor, and so on. No matter what enterprise you undertake (or if you choose to do nothing), these bills must still be paid. Variable costs are those costs that are only incurred as a result of a specific type or volume of production; these usually include feed, seeds, fertilizer, and veterinary expenses. These costs are affected by the actual production that is taking place (Figure 13.1).
The division between fixed and variable isn’t always clear-cut: Some items may be fixed in certain scenarios and variable in others. For example, dollars spent on the purchase of livestock are a fixed cost if you’re purchasing breeding animals, but they are a variable cost when purchasing stockers.
Figure 13.1. (A.) Income is generally a linear function that correlates directly to production. For example, if 1 unit of production creates $1 in income, 10 units will create $10, as is the case in figures A and B. Fixed costs are constant and are unaffected by production. (B.) Variable costs, such as income, are a linear function that correlate to production. For example, if it costs 20 cents in variable costs to produce 1 unit, then it will cost $2 to produce 10 units. In figure A, the farmer needs 5 units of production to break even, but by cutting fixed costs in half (figure B), he needs less than 3 units of production to break even.
Small-Scale Livestock Farming Page 26