Financial planning key to profits
Dairy farmers will also be required to think strategically and plan financially. This will include the ability to assess on-farm investment options, prepare annual and multi-annual cash flows, and identify and manage risks.
When a profit is made you still have decisions to make on how it is best distributed. Looking at discretionary or free cash flow will tell you how you can exert some control over this allocation.
Those were key take home messages at the recent dairy expansion events.
Farmers see a figure labelled profit on their accounts or Teagasc Profit Monitor which looks fairly healthy — but they don’t seem to have the money to match the profit.
Farm businesses are run to make profit. Generally, the bigger the profit, the better the farm has performed.
Farms need to be profitable, to continue to stay in business, and to ensure that the business owners get a reward for the time, effort and money they have invested in the business.
Above is an example of how profit is calculated
The profit figure arrived at after a full year of business is often called “the bottom line” — and the manager’s job does not finish at the bottom line.
While the farm is generating profit, it is also funnelling that profit in different direction to cover paying tax, repaying farm debt, drawings/living expenses for the farm owner, and investing in new assets.
Paying Tax
For some people, being profitable can be a double-edged sword in that higher profits mean higher taxes. Taxes are just another expense, and not a tax-deductible one.
Taxes should be planned for, controlled (legally) and paid, without putting pressure on business cash flow.
It is good practice to also create a standing order from the business account to a separate account to have a tax payment fund in place, so when tax return time comes around the funds are there to pay it.
Repaying farm debt
Paying back the original amount borrowed, also called the principal, is different from interest, which is of the cost of borrowing and which is already deducted in the calculation of profit.
Both the principal and interest are combined in the loan repayment that is made at regular intervals. But while the interest is a deductible expense in the calculation of profit, the principal is not deducted.
Making additional payments against the loan is an option that some borrowers take up, if they want to pay off debt quicker for whatever reason.
Drawings/living expenses
This is cash required by the farm owner to meet personal commitments. These commitments include family living needs, family savings, and potentially saving for retirement, using pensions. Many owners operate a bank standing order from the business to a personal bank account for a fixed amount to cover weekly living expenses, with the flexibility to withdraw extra when required.
Business investment
This refers to new investment — not replacing an asset which was already in use in the business. Any replacement of existing assets is not included here, because it is already included in the calculation of profit through the depreciation charge.
Examples of the type of new investment could be cash invested in new machinery, buildings, facilities or land, any of which could also be part financed by new borrowings.
It also covers cash that is left in the business bank account, unspent yet, but which will still be allocated in the future.
For a farm in expansion mode, this investment can also be seen in the build-up of breeding stock numbers on the farm which are factored in to the calculation of profit through the inventory change figure. Following on from our profit calculation, next we will show how the profit made was allocated.
So we can see that during the year the profit has been fully used up.
This allocation of profit happens every year for every business, and it explains why you can’t just pocket the profit at the end of the year and head for the hills. It also backs up the well- known fact that “Profit is not Cash”.
In allocating profit to these areas, there are decisions to be made, because there is only so much of this profit to go around. Too much earmarked for one area means less for the others.
There are certain cast-iron commitments which must be met — paying tax and paying back money owed are two definite items.
After that, there is some discretion in the allocation of “what’s left”, or the discretionary/free cash.
Calculating Discretionary or Free Cash
Having a clear idea of the discretionary cash (also called free cash flow) is a better indicator of how much is left after we have spent what is required to run the business and meet necessary obligations. This is a real cash figure that exists, and that the business can decide to spend how it likes.
By revisiting our example and showing the calculation of this cash measure alongside our profit calculation, we can highlight the differences between the two.
To arrive at the cash amount within your control, you exclude the non-cash items (livestock inventory increase and depreciation) that were used in the calculation of profit.
You deduct the amount needed to cover tax and debt repayment, and “what’s left” is what you have freedom to distribute.
You will notice that the figure for “new investment” is excluded in the calculation of the cash figure, even though it appears to have already been allocated in the build-up of livestock inventory. You also assume the level of payment of drawings to be within your control.
In this example, the discretionary cash amount of €150 can be spent whatever way the owner pleases. Some of the possibilities for this include:
n Withdraw it from the business as either necessary or additional drawings: there will be a normal drawing amount that the owner feels is necessary, but perhaps if the free cash amount is large enough, then the drawings amount could be increased, and the owner can treat himself and his family in the sure knowledge that the business is not detrimentally affected.
n Invest it in the farm business: this could be on building up stock numbers or on fully or part funding the purchase or building of new business assets such as land, machinery or facilities. Alternatively, the decision could be made to invest this in a deposit account — to bank the funds in the expectation of an investment in the future.
n Make accelerated debt repayments: for some, reducing debt to a manageable level is seen as a priority, and the option taken may be to divert a share of the free cash to paying down debt quicker and increasing the owner’s share of the business.
The only foolproof way of getting a handle on this free cash is by monitoring cash flow and combining this with a forward cash flow budget.
These words may strike fear into the hearts of those who feel they do enough office work as it is, but it is the only way of really taking full control of farm financial decision-making.
Quantifying your discretionary cash and making an informed decision on which of the above three options to spend it on should give the farm business owner confidence that the decision made has a greater chance of being the correct one.
This feeling of “control right to the finish” is the missing link for some business owners in helping them to be confident in their ability to manage the business for maximum return.
