Managing the risk in your business is becoming increasingly important. Typically, people tend to associate risk with negative outcomes. But there can be an upside to risk as well, risk that correlates to opportunity.
For some, the past couple of years have realized perhaps even windfall-like profits with an expectation that, due to a shift in the global demand curve for grains and oilseeds, a longer than historical upside trend could remain. There are numerous factors at play. An example includes a prediction that upwards of 300 million Chinese people will move into the middle class in the next 10 years, a number pretty much equal to the population of the United States.
Accompanying the potential upside are the volatility of commodity prices, increasing input costs, questionable product availability, record-high real estate values, and shifts in global economies.
In the agriculture industry, it’s not just farmers who face this growing management issue. A major grain company has identified a couple of the downside risks it is trying to manage:
Risks associated with end-users such as basis uncertainty, inventory carry costs, and counter party risk;
Risks associated with producers, such as contract integrity and margin exposure.
This company quite candidly states that it is looking to share some of the liquidity risk with farm customers. This is just a little different than sharing in the sandbox.
At an American Association of Production Executives conference last summer, a major U. S. lender cautioned farmers to not take credit for granted. They recognize that they cannot control agricultural cycles and related volatility, but they can better manage the cycles and volatility associated with these periods through customer selection.
They have extensive research data on their farm customers and have learned that the most predictive performance data, in rank order, are: working capital, ownership equity and risk rating.
The prediction of risk varies with loan size and type of operation with the above-referenced predictors even more closely correlated with larger operations. Further, the more focused the customer is on primary agriculture, the more important it is to have stronger working capital and equity positions.
Here are some suggestions:
Consider creating a capital reserve (a short-term deposit of capital) as an option to paying down term debt. This will increase working capital and provide optimum flexibility for a period of time while you watch the current industry situation unfold. Paying down term debt is not necessarily a bad strategy. It does decrease the risk associated with leverage and can improve working capital if it eliminates a payment. But it also typically improves the position of the lender unless you can get them to correspondingly release security.
Take your historical working capital needs and consider factoring in a 100 per cent increase as a countermeasure to volatility. This will be beneficial in the event of a downturn or the occurrence of an undesirable event. It will also be beneficial if unexpected opportunity should arise.
Consider pooling resources with some like-minded producers to access information from an agriculture economist. They will not tell you what will happen. But they will be able to provide you with information that you can use when making management and investment decisions.
Terry Betker is a partner with Meyers Norris Penny LLP, based in Winnipeg.