Planning business finances

2019 is bound to be an interesting year, what with a 20% deterioration of the Kwacha against the United States Dollar, from 9.98605 in January 2018 to 11.98035 on12th January 2019. This amounts to an inflation rate of 8.25% as of January 2019 against an improved real gross domestic growth rate of 3.8%in 2018, to an expected real growth rate of 4.5% in 2019.Additionally, changes to the tax structure with the replacement of value added tax by non-refundable government sales tax may increase costs further. It’s allup in the air as to where, what, how, why and when, but one thing’s for sure –austere times are coming.

Farming is expensive business. Gone are the days when you could grow crops or raise livestock without an elaborate investment in plant and machinery. Consequently, farmers purchase expensive long-term assets in order to produce crops or livestock at minimum cost. Attaining minimum cost requires scale and so it becomes a continuous cycle of reinvestment to achieve scale and profitability. This reinvestment in capital assets can sometimes be a significant drain on cash. Cash going out the business door reduces the value of a business. Furthermore, a significant number of commercial farmers carry huge debts from capitalization and yet they are structured as sole proprietors or partnerships, meaning they are personally liable for these debts. Discuss your structure with your accountant and you may find that limited, rather than personal liability, is more appropriate for your business. I discussed this in the October/November issue of The Zambian Farmer.

The absolute starting point is determining your strategy. Farmers sell commodities whose prices fluctuate. Commodities have no distinction or differentiation and farmer A’s wheat is no different from farmer B’s. And, we all know that commodities never earn a premium. Therefore, to earn large profits requires scale.  Any farmer therefore has to be a low-cost producer to succeed and if he/she has any chance of reducing the time to profitability.

The commercial farmer usually has a contract with the buyer, detailing quantities to be delivered in the future at a predetermined price. The contract may be US dollar based or Kwacha or a mix of both. Since seasonal income is easily determinable, banks love the farmer and they will lend money to him or her in the form of short-term, mid-term and long-term financing, depending on the value of the collateral the farmer is willing to risk and the value of the crops and all other assets owned by the farmer. Bank loans tend to be over collateralized with bank risk being slim to nothing.

Protecting erosion of income streams is the farmer’s first consideration. Before signing away the farm and all, the farmer should shop around and see what rates of interest and terms are on offer. Important considerations are the rate of inflation and the “risk-free” rate of return on Zambian government treasury bills. Remember that you are competing for financing with the Zambian government and the banks want your offer to be compelling.

Figure 1. Returns per Bank of Zambia vs. Surplus interest charge by a typical commercial bank

The typical bank earns an extra 8% in interest by lending to the farmer rather than the government. This is why banks love the farmer. Most farming businesses hardly net profit margins of 8% on crops or livestock – real or nominal. So, whilst the banks may be a necessary and more willing lender than friends and family, the farmer should compute what he or she is paying to the bank in excess of what the government would pay. The illustrations below demonstrate that a 1%reduction in interest rates from 27% to 26% could save the farmer K5,800 in interest charges. Also remember that the banks will want to  charge an arrangement fee of approximately 2.5% to 3% and there will usually be additional costs for  insurance, legal and valuation fees that can easily add up an extra 6% in charges. Therefore the real cost of a loan can easily jump from 27% to 36%. The farmer must negotiate all these charges.

Figure 2. Seasonal loan@ 27% interest charge

Figure 3. Seasonal loan@ 26% interest charge

Figure 4. Key ratios that the farmer needs to monitor
Suggestions for alternative financing are trade or supplier credit and equity investment or debentures.
Though limited, supplier credit is usually the least expensive since it is built on prior relationships and trust. For example, ABACUS360 needed a printer for additional work arising from a specific assignment requiring tremendous volumes of print. Our printers at the time were completely inadequate and would have cost substantial Kwachas in ink. We approached our supplier of printing machines and products and explained our predicament. A handshake, exchange of post-dated cheques and we had a brand-new state of the art printer at less than what a bank loan or lease would have cost. The farmers should leverage relationships by treating suppliers as integral partners in their business. This may mean mending broken relationships and making some concessions for the long-term. Cutting the middleman saves costs.
Most farm businesses are sole proprietors and as such seem to only raise money from family. Restructuring the business from a sole proprietorship to a limited company can bring possibilities of raising money from third-parties that have confidence in the business. This alternative financing could be in the form of debentures or shares with differing characteristics. It is very important that the farmer structures financial needs with the perspective of how long it will take to reach profitability. Profitability for a farming business can easily take 10 years. One of our commercial farm clients only achieved profitability in the second generation. Bank loans poorly managed will strain profitability and may even erode the value of the business.
Planning company finances requires investing time in determining acreage, yields, money coming in and out of the business, etc. Financial planning is critical and a farmer will achieve success sooner if he/she does this as part of operations at least annually. Financial planning will create a culture of financial discipline that is pertinent for a low-cost volume business that sells commodities. Failure to plan what the best cash inflows and outflows are will result in long-term failure and a low value business that nobody wants to buy should the farmer want to sell. The annual financial statements that farmers demand from their accountants for tax filing are less important than the financial planning required for the business.

The farmer’s financial forecasts should contain a projection of cashflows for at least one year, a budgeted balance sheet and profit and loss account. These numbers must be reviewed at least quarterly with discussions and explanations for material variances and corrective action. If you can’t measure it, you can’t manage it!