The writers of Seinfeld thought the field of risk management was obscure enough to serve as the foil for George’s pathetic career efforts. I can imagine them asking, “Other than rocket scientist, what career would amplify George’s lack of skill, organization, and work ethic…risk management!” Risk management has mystique. It is business savvy mixed with statistics and machine learning algorithms. This article will help you break down and demystify risk management as it relates to the row crop farmer. What is the secret to long-term, profitable farming? This secret will be most applicable to the established farm; unfortunately, it is very difficult to start farming from nothing today.
What is the secret to long-term, profitable farming?
Farming works for the banks making operating loans. Just so that does not come across anti-climactic, here is the secret restated: ag-lending banks are in the business of buying growing crops in exchange for 3-5% ultra-low risk returns. You should be in this business. You have right of first refusal as to whether it is your money or the bank’s that funds your growing crop. Strive to cut the bank out of your life. It may take decades, but you should be in the business paying for your own seed, chemical, and other materials in exchange for 3-5% ultra-low risk returns.
What does “ultra-low risk” mean? The banks loan into a crop with the only risk ultimately being that liquidating your assets may come up short of what you owe. Further, banks have learned to pull the plug on farms while there remains enough cushion to mitigate this liquidation risk. You own all the production risk, as you have collateralized the loan.
Know the bank does two things:
- Only expects modest returns from farm operations
- Offloads all the production risk onto you.
How do you manage risk?
There are many ways to manage risk as a row crop farmer.
- Buy the crop insurance. Buy the best crop insurance. Pay for the policy extensions.
- Stop signing marketing contracts that take all the upside (even doubling the required bushels when prices soar) while only taking a portion of the downside.
- Diversify geographically as much as possible. Diversify commodities as much as possible.
- Reduce production risk as much as possible (i.e., irrigate).
- Apply for all the government programs.
- Strive each year to reduce the size of your operating loan.
- Only expand acres when you can do so without having to borrow 100% of the money needed to put a crop on it. Minimize capital spending by maintaining what you already own. Do not over-leverage.
- Keep the gross revenue size of your business to a fraction of your total equity in the business. Consider off-farm work to supplement your living needs if an appropriately leveraged farm is not big enough to live on.
It is important to understand that the farmer sits in the weakest position in the value chain. Weak players do not command premiums in the market. They strive for low cost. They receive low rewards. In the risk-reward relationship, what goes with low reward? Low risk goes with low rewards. Risk management simply means ensuring a reasonable relationship between risk and reward.
If you farm less than a million acres, you are a weak player in the value chain. Therefore, offload the risk. Do so by paying speculators and insurers to take it from you. Do not grow your operation beyond your equity that underwrites it. Reduce your size if you already operate too big. Instead of making the banks rich, strive to own the asset with the highest asset turnover ratio (ATO)–the growing crop. Imagine finally getting to the place of collecting a relatively risk-free 5% on the millions you have invested in each year’s growing crop.
If you could use help with your farm’s financial processes, contact a professional for help. For ongoing updates with helpful insights for your farm, subscribe to Ag Advantage, the AgriSolutions blog.