By: Jason Fewell
Originally published by Dakota Farmer at farmprogress.com
Risk and uncertainty have a great deal of influence on farm and ranch profitability. However, risk is not the same as uncertainty, and understanding the differences can help farmers and ranchers make good financial decisions. Most farmers and ranchers do a good job managing risk on their farming and ranching operations, but uncertainty is nearly impossible to manage.
We can measure risk by knowing the probability of a known outcome occurring. On the other hand, uncertainty is not measurable, since we do not know what will happen in the future and therefore cannot measure it. If risk can be measured, it can also be managed. Insurance companies measure the risk of some adverse event occurring based on history and adjust premiums accordingly. Option prices for commodities or stocks are calculated with the risk, or volatility of the commodity price, included in the calculation.
Producers can manage risk by hedging or using options, forward selling, buying insurance, and so on. However, managing uncertainty is not possible. We face a great deal of uncertainty every day. Political and global events create a great deal of uncertainty that affects agriculture and is out of producers’ control.
Is there a way to manage uncertainty? The short answer is no. However, we can make decisions that put us in a better position to handle the occurrence of uncertain events. The first is to maintain working capital. Having a strong working capital position allows you to continue operating even if some unknown event causes a shortfall this year. It allows you to still make debt payments or cover family living expenses without having to borrow more money or sell assets. To be in a strong working capital position, you should have a liquidity position of at least 30% of your annual gross income or 40% of your annual operating expenses.
Minimizing debt can also improve your ability to handle uncertainty. If you think adding debt payments will cause tighter cash flows in the future based on current events, imagine what could happen if a new global war causes oil prices to jump or commodities to fall due to a lack of global transportation. When evaluating purchasing decisions that will add debt, it is wise to stress-test the projected cash flow plan with a five or even ten percent increase in expenses or drop in income to account for some unforeseen catastrophe, and see if payments could still be made.
Another way to manage the unknown is to know your cost of production, including family living expenses and any other profit you might need. Knowing the cost to produce a bushel of grain or a unit of livestock allows you to market your products at a profit. This will help keep your cash flow positive. Cash flow is king, and making good grain and livestock marketing decisions will help maintain your cash and working capital to be prepared for uncertain events.
Communicating with your business partners, family, lender, and other advisors will help ensure stability as well. Make sure everyone understands your need to be at least slightly prepared for the unknown. Be sure that your business partners and family members understand the need to maintain a strong working capital position, even if it means foregoing some wants.
Managing both risk and uncertainty is important for every operation. Futures and options markets, many insurance products, and other types of risk management strategies abound to provide peace of mind for producers. But managing uncertainty is much more difficult. Uncertainty can create a great deal of stress. Making good financial decisions can alleviate that stress and provide stability in the future.
Fewell is a North Dakota Farm Mangement Education Program instructor at Lake Region State College writing from Carrington. The North Dakota Farm Management Education Program provides lifelong learning opportunities in economic and financial management for persons involved in the farming and ranching business. Visit ndfarmmanagement.com, Facebook @NDFarmManagementEducation, or contact Madison Bodine, State Supervisor for Farm Management Education, at mbodine@nd.gov or 701-328-4567 for more information. The ND Farm Management Education Program is sponsored by the North Dakota Department of Agriculture.