Graphic Business News

Understanding and managing risk in a farm business

By: Graphic Business
Farmers need to sign on to insurance policies due to inherent risks in agric business.
Farmers need to sign on to insurance policies due to inherent risks in agric business.

Many decisions in agriculture are taken without a clear knowledge of what the specific outcome will be. Farm businesses often find that their best decisions turn out to be less than perfect because of events that occurred between the decision and its outcome. 

Crop farmers, for example, are often faced with decisions about which crop they should plant, the amount of fertiliser they should apply and what other inputs they should use in the early planting season. These decisions are made before the farmer knows what the ultimate crop yields will be and what prices will be obtained for the crops.

A cattle farmer who decides to expand his enterprise may have to wait several years before he can receive income from calves, for example. Unfortunately, farmers can do very little to speed up the biological processes on which their production depends, or make them more predictable.

The above examples paint a clear picture of how risk is inherent in agriculture and how complex the management of this risk is.  Risk comes from unexpected outcomes, often with serious financial implications, and managing it is largely about reducing the possibility of unfavourable outcomes or at least softening their effects on the business.

It is important to understand that for any business, good risk management does not necessarily mean total elimination of risk. Rather, it means controlling the risk to a level that the business is willing and able to bear.

A good risk management strategy requires a hands-on approach that integrates all the business functions of the farm, so that the total farming risk system is managed proactively and in conjunction with both the external and the internal environment of the business.

When dealing with risk, it is also important that to understand that there is no straightforward approach. It is also important that farm businesses are as flexible as possible for risk management strategies to be successful.

Various risk management strategies, such as enterprise diversification, vertical integration, production and marketing contracts and insurance products, are available to help farm businesses cope with risk.

However, farm businesses are not all the same and they cannot have a blanket solution to their risk exposure. Financial position, the size and type of the farm business and various other factors play a huge role in determining the enterprise’s ability to shoulder risk.

Loss mitigation

A well-established farm business with a large amount of equity capital can afford not to insure as it is able to withstand larger losses before it feels the total impact, while a smaller enterprise that has just started production cannot afford to forego the option to take out insurance as a strategy to cushion the risk impact on their business should the unforeseen occur.

The farmer’s use of debt to finance operations and his debt choice depend on many factors, which include the level of risk aversion, the size and type of the operation and the performance and positioning of his business within the market.

In general, a highly leveraged farm business has greater financial risk than does a farm business that operates in a less leveraged financial structure. Highly leveraged farms whose debt exceeds their assets can lose equity, especially when they cannot afford the cost of the debt.

These businesses will be more exposed to financial risks such as those related to high interest rates. In such cases it is often advisable for farm businesses not to borrow capital or at least to wait until their position improves. This could mean they will have to postpone their capital expenditure.

In reality, however, it might not be practical to postpone capital purchases indefinitely, but the business must be flexible and could prioritise on operating expenditure instead.

 A healthy cash flow is also very important for risk management. If a farmer has high living expenses, he will be less able to withstand a low-income year. It is important that farm businesses maintain their liquidity by taking care of short-term liabilities that are necessary for a healthy continuation of operations. A dent in the business cash flow because of technical or market factors such as a decline in the price of a product can have an impact on farming income.

It is important that farm business managers study the different types of risk as well as their impact on the business. They should identify the mitigation strategies available for each type of risk and prioritise them according to their potential impact on the business. 

To assess and analyse risk, business managers must be able to formulate probabilities and analyse a wide range of potential outcomes for different decisions. These probabilities are useful for forming expectations. The true probabilities are seldom known but are always subjective.

The probability of rainfall or the odds of changes in interest rates, for example, are subjective probabilities. Farm businesses differ and the interpretation of available information will vary from business to business. When all the probabilities and their outcomes have been formulated and weighed against each other, a suitable decision can be taken and implemented with a suitable risk management strategy.

Classification of risks

Risks must be classified not only according to their sources but also in terms of how often the negative impact occurs and what the magnitude of the impact is. Risk management starts with decisions taken on the ground, such as which output to produce and which inputs to use for production. 

Businesses must arrange risks according to their impact and the probability that these risks will occur. The potential impact can vary from catastrophic to minimal and the probability can vary from highly probable to improbable.

By evaluating each possible risk according to the above criteria, a producer will be able to discern between risks that require immediate attention and those that are less important. The risk remaining after all risk mitigation has been implemented is known as residual risk. This is the risk that the business simply must cope with in flexible and strategic ways.

There is no generic risk management strategy that works for everyone, nor can a risk management strategy be used for every season. It is important that businesses consider their own risk appetite and tailor their strategies for maximum benefit. Standard Bank Agribusiness Unit/GB