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Profiting from Risk

Posted Jan. 1, 2002

Managing risk is essential in today's volatile farm economy. Serious consideration should be given to developing and adopting a formal risk management plan. Preparation of such a plan should lead to better decisions which leads to a greater peace of mind. Generally, the more risk you take the greater the profit you will experience. Producers should try to balance risk and reward. A farm business should be managed to produce the highest net income for the level of risk a producer is willing to accept. A risk management plan is different for each farm business due to each manager's attitudes towards risk, their business goals, and unique set of farm/ranch resources. Incorporating a "risk management process" into the daily management of the farm business is a key to a successfully managed farm business. Developing a short and long range business plan is the first step in this process. Once the goals have been established, an implementation plan must be created to complete the objectives of the goals. Risk management alternatives must be addressed within the implementation phase of the plan. Managers should develop risk management strategies. Risks can be categorized into at least five primary categories: Production, Marketing, Finance, Legal and Human.

Production risk is typically managed by diversification of enterprises and insurance.

Market price risk is inherent to all producers because they are "price takers." Developing a marketing plan that incorporates a breakeven analysis is the first step. The type of risk management tool producers should utilize depends upon the type of price variation. The four types are seasonal, cyclical, trend and random fluctuations. Daily prices are the most closely monitored which typically follow a seasonal pattern. Price cycles are generally predictable and are created by structural changes in supply and demand. The annual market trend can be monitored by the basis which is the difference between the cash and futures market. Basis contracts, forward contracts, futures, and options are all useful "marketing tools" to manage price risk.

Financial risk can be assessed by developing the following financial budgets and statements: Cash flow, Income Statement and Balance Sheet. The information in these financial documents is used to calculate important financial ratios. The absolute value of the financial indicators will inform the producer how much financial risk he can withstand. For example, a producer with a high level of financial risk would have a debt to asset ratio of .75 and a liquidity ratio of .10.

Legal risk for a farm business is generally in the areas of contracts, governmental regulations and business succession plan. There are many types of contracts that producers can potentially engage in: Lease, Marketing, Production, Input Purchases, Capital Assets and others. There are countless local, state and federal regulations that present risks if the rules and regulations are not followed to the satisfaction of the governmental agencies. Another legal risk that farmers and ranchers experience is the transfer of the assets to the next generation. Legal assistance should be sought to develop a succession plan that fulfills the desires of the asset owners. All types of legal risks can be evaluated by engaging the services of a competent attorney.

The last major risk category is human risk. Managing people exposes the farm business to human risk. Effective communication is an essential ingredient for a successful farm business to reduce the level of human risk. Informed employees perform more efficiently which leads to reduced risk.

Having a risk management plan can reduce risk within the operation, transfer risk outside the operation and build the farm business's capacity to bear risk. Producers should ask the question "What am I willing to lose in my farm business?" It is a prudent business management strategy to prepare a risk management plan for those risks you desire to manage.