The idea of “saving for a rainy day” traces its roots back to at least the 16th century, but it may as well have originated on an American farm.
Most producers inherently understand that they operate in cyclical industries. These cycles ebb and flow with strong profitability in some years followed by very weak or negative margins in others. Because most producers realize that there will be challenging years in their operations, they know to hold onto profits in a strong year to ride out the weak part of the cycle. For that reason, they may allow their balance sheets to expand in good years with solid margins, and then let the ledger erode during bad times. But leveraging hedging tools to maintain a consistently strong balance sheet may offer a better alternative.
Some producers mistakenly think that the costs involved with hedging means that active risk management is not worth the effort. In order to remain viable for the long term, they may focus on being the lowest-cost producer, in the hope of simply outlasting their neighbors.
A producer, or their accountant, analyzing hedge performance over several years of active risk management would likely see realized hedging gains in some years offset by losses in others. From a purely numbers perspective, they may reasonably conclude that there was little or no net long-term benefit. This is especially true when one considers the expense of hedging in terms of transaction fees, interest expense, staff time and other costs.
However, while the balances of a hedging account or group of accounts may fluctuate over time with the volatility in the underlying markets, they also help stabilize the balance sheet. In bad years, the operation will likely lose money in the open market on spot purchases and sales, but to the extent these losses are offset by hedging gains in a brokerage account, the balance sheet will not experience the erosion that would otherwise have occurred. The reverse is also true: in very good years, the losses in a brokerage account will not allow the balance sheet to expand as much as it would have otherwise.
This steadying of the balance sheet also helps to improve cash flows. By actively managing forward profit margins, agricultural operations narrow the range of possible outcomes in a given marketing year or period. As an example, let’s say Producer A made $6 million in 2015, then lost $4 million in 2016, resulting in a net outcome for the two-year period of a $2-million gain. Contrast that with Producer B who made just $2 million in 2015, then broke even in 2016. While he ended up with the same $2 million net gain, unlike his counterpart, Producer B maintained a positive cash flow over the two-year period. As a result of that difference, he would likely have been better able to stay current with the operation’s bills.
Benefits of a Steady Balance Sheet
Besides positive cash flow, there can be other benefits to reducing variability in the balance sheet. In consideration of the desire for most operations to remain viable for the long-term, gaining stability and predictability in cash flows can allow a business to confidently make decisions about long-term operational improvements that might require multi-year investments. For example, by expanding or incorporating improved technologies, an operation may be able to gain economies of scale that serve to lower the costs of production.
A bank will most likely have more confidence in lending to an operation with a stable balance sheet and cash flows, making funding easier to facilitate these investments – particularly in down years or negative parts of the cycle when the investments might be less costly. By contrast, operations with eroding balance sheets may forgo investing in their businesses. Restricted cash flow may also lead to strained relationships with lenders and input suppliers.
Reducing variability in earnings and cash flows will also assist in transitioning the business to the next generation through succession planning. In addition, the business will be less likely to fail if the balance sheet is more stable from year to year. Perhaps most of all, a strong balance sheet helps empower you to achieve your long-term vision for your operation.
If you would like to learn more about how you can keep your balance sheets strong throughout the year, please call CIH at 1.866.299.9333.