One of the joys of writing this column is to expand upon questions I get in seminars or via e-mail. The following question came from one of my loyal online readers concerning profits.
“I farm corn and soybeans in Iowa and had a strong year with excellent yields and high prices. How should I spend these profits after taxes? Should I pay down machinery installment loans or simply pay cash for my 2009 crop inputs? I want to strengthen my working capital.”
Congratulations to my reader from Iowa on a profitable year. In our business, we have used the 60-30-10 rule — sounds like a fertilizer analysis — to develop strategies for profits.
First, 60% of profits are used toward the ultimate goal of increasing earned net worth. This can be done by paying down debt, incrementally increasing the size of the business or building efficiencies. While most producers want to get their land paid for, I suggest paying down the highest-interest cost, shortest-term debt first.
Your ultimate goal is to increase working capital to 33% of revenue or expenses, particularly if you have growth plans or project tremendous volatility in revenues or cost and have no marketing or risk management plan.
Utilize 30% of profits specifically to build working capital. Yes, you may be required to pay income taxes, but the ultimate goal is to have a financial fortress for unforeseen circumstances or to take advantage of opportunities. Even cash in the bank at a low rate of return can net you a long-term high rate of return. In a deflationary environment, your dollars go further in acquiring assets at 70¢ on a dollar.
Be careful of prepaying or just paying cash for all inputs. Conduct financial due diligence on your suppliers and agribusinesses to make sure they are financially sound. Second, bargain for discounts with your cash to lower your cost of production. Third, hold a little cash in reserve for rainy days.
What about the remaining 10%? That is for you to use at your discretion. Any strategy needs to be tested against your business, family and personal goals.
DEFLATION AND INFLATION
The worldwide economy is deleveraging, creating a deflationary environment. In this type of environment, cash is king — even if it returns little in a money market or savings account — because cash can purchase more as asset values decrease. Examples are everywhere as businesses and consumers unload inventory.
While this describes the current economic environment, stimulus packages in the U.S. and globally may result in the opposite scenario: an inflationary economy. This may be particularly true if the government opens up its money printing presses, increasing the money supply, which makes federal debt cheaper as the result of inflation. This is freshly minted currency chasing scarce goods, which could result in hyperinflation.
Both scenarios present challenges to managing a business. How does one prepare for each environment?
- Keep your debt level modest and well within your ability to pay it back given a wide range of economic scenarios.
- Maintain financial flexibility with strong reserves of working capital. In either environment, businesses must control overhead and fixed cost commitments. Budgeting and planning will be critical, requiring big-league management strategy, but more importantly, execution.
- Diversify your strategies for marketing products, purchasing inputs and managing interest rates to remain flexible in uncertain times.
Dave Kohl, PhD., Corn & Soybean Digest trends editor, is professor emeritus at Virginia Tech. He's published four books and over 500 articles on financial and business topics. You can reach him at [email protected].