Transcript

3 Baron-Hay Court, South Perth Western Australia 6151Telephone: +61 (0)8 9368 3333 Fax: +61 (0)8 9474 2405Email: enquiries@dpird.wa.gov.au

Financial intelligence webinar 2: Longer term financial decisionsIn the audio is:

Doug Watson, Consultant, Australian Facilitation Company

Transcript

Doug Watson:

Good morning everyone and welcome back to Webinar 2 in our series on Financial Intelligence. I will just enlarge my screen here so you can see, Ive actually got some flowers in the background. My wife thinks I brought them for her, but actually I brought them for to have something in the background when I am doing the webinar, but don't tell her that, because I want a few brownie points.

There are no notes with this session. There is just the PowerPoint slides and the homework or post webinar activity at the end. But there are lots of references at the slide at the end there, which has quite detailed information that can help you with all of the stuff that we talk about during the webinar here today. So there is generally a description on the left hand side of the reference. They are all web based references, so you should be able to just click and get more information if you are struggling with a certain point or issue.

Okay, so let's get into a bit of a content for today's webinar or positioning of today's webinar, because in Webinar 1 we did the financial basics and also some feedback from Webinar 1 where some people were suggesting that whilst it was of value, was it of great value in terms of the farm and making decisions. And I can understand that getting that basic information until we look at the decisions it can help you make might have seemed a bit tedious or for some people it might have been something that they already were very comfortable with.

But we are all on the same page now, we have got some financial basics and if you recall from Webinar 1, we looked at the farms financial position from three perspectives, exactly the same as how a bank would look at your financial position if you went for a loan. So we look at the past which is to do with your profit and loss, what revenue and expenditure has happened. The expenditure is the costs associated with generating that revenue and we need to match those two together. We looked at cash flows which many people are very familiar with, and that's more about the here and now and what's happening right now and can we pay our bills when they fall due.

And then we looked at the balance sheet which is more about the future and how you set yourself up for the future, because we defined assets as something you owned that has value into the future and we define liabilities as monies you owe that you have got a future obligation to repay. And what we looked at is the difference between what you own and owe is called your equity and that's a measure of your financial wealth. And we did discuss in Webinar 1 that from most farms even though you might have independent goals in the long-term you are aiming for if we were to summarize them many of them would come back to sustainably grow your wealth in the long term. So we want to have more money available so that we have a bigger safety margin if there is a bad season.

We want to have more money so we can invest in plant equipment, we want to have more money to hand the farm over in good order, we want to have more money to improve our standard of living. All of these things come back to sustainably growing your wealth which is measured by that equity. So we did see there was some links between the different financial statements, cash flow, the cash amounts reported in your balance sheet, and the profit and loss is how you grow your equity, its profit that grows your equity not cash. So hence why we are going to focus quite a bit on profit and costs of production and that sort of thing in Webinar 3 the next webinar we get to.

So there is two sides to any financial transaction, otherwise a balance sheet won't balance and we need to understand those two sides to understand the transaction fully. We looked at a couple of adjustments to take us from cash flow to profit and loss. Balance sheet information that we can use and the main two adjustments we looked at in terms of creating a profit and loss from your cash flow was about matching revenue with expenditure, so if the revenue didn't happen this year then it shouldn't be recorded this year.

And similarly if you haven't received the cash for this years revenue, you need to make an entry to record that cash. So this has to do with the increases and decreases in your tradable assets, stock on hand, grain, fertilizer, sheep, all sorts of things. And similarly if we have incurred an expense this year, but haven't paid for it yet, we need to record that. Or if an expense or a cash withdrawal is in this year's cash flow, but relates to a previous year or a future years income then we need to be able to remove that expense to match revenue with expenditure.

And then when we have apples and apples comparison, 2016s revenue with 2016s expenditure, we are in a better position to make decisions. The final adjustment we made was to your balance sheet and take it from a compliance type balance sheet to help record things for maybe the tax office and move it into a management balance sheet that helps you make better decisions by changing the book values to market values. And making sure we do that in a consistent and conservative manner, and over time building up a track record of the different aspects of your farm in terms of assets, liabilities and equity.

So where are we heading from here now that we have just reviewed a bit around financial basics in Webinar 1, we are going to look at long term financial decisions. And you may recall the analogy in Webinar 1 about Alice in Wonderland, you know Which road do I take? If you want to sustainably grow your long term wealth, then you need to have some long term goals and objectives. And those goals and objectives need to be considered when you are making short term decisions. If you don't have an end destination in view, then often your short term decisions can become very kneejerk and responsive, reactive rather than proactive. And, you know, there is a good deal on fertilizer, remember I wanted to buy a whole heap. Well, you need to stop and think about Well, whats that going to do in medium to long term not just in the short term. So should I keep the lambs and sell them in a year or twos time, and shear them another couple of times, that's more of a long-term sort of decision. It's going to have longer term implications than just a short term cash flow of not getting the money for the lambs.

We need to balance those decisions and align them such that we get the best outcome. So longer-term decisions we defined in Webinar 1 as three plus years, three to four years maybe the rotation of your farm. Then we are going to have some medium term decisions which is more over the operating cycle of your farm which might be sort of one to three years, and looking at your profit and loss and cost of production to help guide those decisions. Then the fourth webinar we are going to look at short term financial decisions which is largely around your cash flow and making sure that you are going to have money to pay the bills and you are optimizing performance in this current season. So that's within a season, this is across several seasons and the longer term is three, four, plus type seasons.

And finally the last webinar, we are going to look at managing financial risk, the different issues that you need to consider across all three different time horizons to try and build your wealth in a sustainable manner. And the risk needs to fit with your profile, otherwise it's not going to be sustainable. So we got some learning outcomes for this particular webinar and they are listed on the PowerPoint there. First off just re-clarifying the long term goals of your farm. I want you to think about what you are actually trying to achieve. Actually before I get too far on setting things up, any questions about Webinar 1 and the context of Webinar 2 before we get into the content for Webinar 2?

So just in the chat box if you have any questions, I will just give you a chance to type them. So I have got a question or two coming through, I will change to my face so you can see me answer the question. Also, waiting for the question just [audio break] [0:09:03] the goals that you are setting and how they fit in with that sustainably growing your wealth. Do you include GST in cash flow and without GST and profit and loss in the balance sheet? Yes, good question, Webinar 4 around the cash flow we will talk a bit more about that, but I think its definitely a cash flow issue because there is going to be money coming out of your bank account.

But its not a profit and loss issue because its not your money, you are collecting it for someone else and you are paying it off to the taxman, so you are acting like a tax collector, if you like, for the taxman. Now it will impact on your cash flow in terms of [audio break] [0:09:41] or send it off to the taxman but generally at this stage we are excluding GST from the profit and loss. In the balance sheet it might show up when your accountant prepares the balance sheet based on if you owe any money in terms of GST, just to highlight that you owe that money, but we will talk more about that when we get to the cash flow. At this point in time excluding it because it's not yours, you are just collecting it, holding it, and then sending it on.

Any other questions? Thank you, Christine, much appreciate it. Also appreciate it, I will go back to the slides so you don't have to look at me.

Have firmly in mind what is your long term goal and we are going to be talking about how we can try and set some objectives and make some decisions that help towards that long term goal. So that's the strategies that we need to overlay our short term decision making with if we want to achieve that long term goal. So that's like a map in terms if you have got a destination and we are trying to navigate the best path in terms of getting to that destination, rather than taking a long and winding road as the Beatles once said.

So our third objective is around benchmarking, so we are going to be talking about financial benchmarking which is a little bit different to physical benchmarking. Now we will talk about physical benchmarking, things around yield and that sort of thing in Webinar 3, but we are talking about financial benchmarks here, things that your accountant and/or banker might look at to determine your financial health and these are going to help us in terms of determining the [audio break] [0:11:32] the opportunities and threats in the farm for you to set some longer term objectives and goals to actually address those.

So we are going to be focusing a fair bit on the balance sheet in terms of these longer term goals, because that is what the financial statement which covers much of the future rather than the present and the past. So having set some goals, let's just review a couple of things here in terms of the information we already have. So the homework activity from Webinar 1, you would have built a profit and loss. So what we have here is a profit and loss that is very similar to what you have built but maybe just summarized a bit differently. We have added some different figures together, so it's a very high level sort of profit and loss without the detail, because we are trying to use it as a learning activity rather than try to reflect reality exactly. So let's just look at things line by line and see where these figures come from and review this high level whole-of-farm profit and loss. And we are going to use the figures in here to actually calculate some financial benchmarks and that's why we have rearranged it a bit differently.

So at the top there you can see gross revenue, the total sales and revenue for the farm and we have got a nice round figure there of a million dollars, this will sort of vary and go up and down I guess based on the enterprise mix, the season, whole range of different things. We have got some variable costs and these variable costs in our previous activity we talked about cropping costs and livestock costs, we are adding them together here to get total variable costs. Now what variable costs are, are the cost directly associated with producing your revenue. So for cropping I guess it would be the cost of harvesting and freight and fertilizer and chemicals, for sheep obviously it would be the shearing, it would be freight as well I guess, it would be all the costs associated with I am going to use terms that I dont fully understand, but mulesing and I guess drenching and all sorts of things to keep the sheep healthy and to get the wool off them and to get them to market. So the cost we can [audio break] [0:14:04] that we have had contractor to come in and shear the sheep, that's going to be a variable cost.

And we call them variable because often they move with the scale of the operation, the more of your revenue, the more sheep you have, the more tons of wheat you have, the higher these costs can potentially be depending on a number of other factors. And we will look more closely at this in a future webinar, but if we just have a sense the variable costs go up and down and are directly related to each dollar of revenue. If we take our variable costs away from our revenue, we get something called gross margin and this is for the whole of the farm. It would be your enterprise gross margins - your sheep, your wheat, your canola, your lupins or whatever oats, all added together if you were to do it on an enterprise level. We are looking at the whole of farm level and we have got 625. One million less 375, 625.

Then what we do is we take off overheads and we separate overheads from variable cost because they behave differently and because we can't allocate them or allot them simply to each enterprise we have on the farm, overheads tend to be a bit more fixed in nature. They don't tend to go up and down with how much revenue we generate. So it might be things like interest which is independent of your revenue, rates, leases that you are paying, insurance bills, maybe you have wage bills that you actually pay to staff. These sorts of things are called overheads and they behave differently to variable costs, so we separate them out. They tend to be a bit more fixed in nature irrespective of your revenue that's going to be your sort of overheads by and large.

So if we take our overheads away from our whole-of-farm we end up with this operating profit, sometimes referred to as EBIT. EBIT is an acronym, it stands for Earnings Before Interest and Tax, simple word for it operating profit.

We have this subtotal because it's a good measure of the operating efficiency of the farm, before you take off things that you have little control over finance costs, tax, that sort of thing. Tax is dependent upon your tax structure and tax rates, finance costs on interest rates and bank margins and things like that. So operating profit EBIT is often seen as a good way of measuring how well is the current management of the farm managing the farm. Then we take off our finance costs which could be lease or interest payments, and we end up with net profit before tax, in this case 180. Now we are going to take off Drawings or depending on the structure of your farm, it might be called a management fee. This is the return for the effort you put in, in managing the farm, okay. Then we end up with some tax which is dependent upon your tax structure and at the very end we end up how much the owners wealth has grown, 75,000 in this instance, that is your net profit after tax.

And you have to make some decisions about that 75 grand, what to actually do with it, and that's going to be critical to your long term plans as to what you do with that discretionary amount of 75. Now the 80 we have in there [audio break] [0:17:36] if you own and run a farm I think you should be getting money in two ways you should be getting a return on the risk and the investment you have in the farm which is down here in the profit how much your wealth has grown, and you should be getting some money for the time and effort you spent in running the farm. You know, what would we pay a farm manager to do what we do if we didn't do it?

If we don't do that we could be kidding ourselves, we could put in a very low figure there and live very frugally and it makes it look as if the farm is more profitable and then all your ratios are going to be distorted because you have tweaked things to deliver a better outcome because maybe it's a bad season and you are not going to take much out in drawings.

For the purposes of working out ratios, we are better off putting in a figure that is more reflective of our time and effort and it may not be what we actually took in drawings, but if we want to get a figure that we can work with and use and compare to others and compare to benchmarks and consistently compare from year-to-year, then let's put in a figure here based on what would we have to pay someone to run the farm if we werent doing it. So the drawings in my view is more like a management fee, its like the return for the effort you put in during the year. The net profit is the return you get for the investment taken in running the farm, two separate ways to get revenue or returns on your investment in the farm. So we have restructured our balance sheet a little bit differently to come up with some different subtotals, but the information for this profit and loss is from homework activity 1.

So let's move on to just review a little bit around our current assets, I am sorry our balance sheet. So our balance sheet we are going to put into different categories and the main categories are going to be current assets, current liabilities, noncurrent assets, noncurrent liabilities. And the definition of a current asset is something that turns into cash in the normal course of the business in the next 12 months. So we want to separate those out from the noncurrent assets which don't turn into cash in the next 12 months because that's going to give us better information for making decisions. So you can see the current assets, your account receivable, your lambs that you have got to sell, any grain on hand and any fodder these things that turn over and turn into cash reasonably quickly and noncurrent assets tend to be different in nature. They tend to be plant and equipment, land and buildings and we manage our noncurrent assets differently to our current assets. We might be rotating current assets, we might be looking for the best market price to sell at a short notice, we might be having to store and manage and deal with our current assets but our long-term or noncurrent assets we tend to sort of set and forget.

We put a maintenance plan in place, we use it the best we can, but it's a different form of management to our current assets. So we are going to separate those out and have a current asset total, and a noncurrent asset total. And together the 156 current assets, together with the 4210 noncurrent assets gives us our total assets of 4366. On a similar basis if current assets turn into cash in the next 12 months then current liabilities are due to be paid in the next 12 months. So an overdraft that we need to sort of try and get back to zero, we got some accounts we need to pay and we have got some lease payments due in the next 12 months and they are all there. This gives us a good sense of potentially the cash outflows that are happening over the next 12 months.

And then we have got some noncurrent assets, so beyond 12 months we have got this big time loan that we need to try and pay off and pay the interest on and we have also got the lease on that equipment beyond 12 months. So the next 12 months payments are 8 and then beyond 12 months the repayments are about 70 there.

So we have got some current assets, current liabilities sorry, 146 and we have got some noncurrent 920 and together they add up to 1066, sorry about the zero dropping on to the next line there. If we take 1066 away from our total assets 4366 we can see that our equity is 3.3 million. You can also see some letters beside each one of these, and we are going to use those letters to calculate ratios. And there were some letters actually beside each one of their profit and loss items as well. So when you are doing the homework, those letters will help you work out the ratios with an example I am going to show you in a minute.

So just a brief stop there in terms of are we quite comfortable with the profit and loss and the rearrangements we have made and indeed the balance sheet and the categorization of assets and liabilities into current, noncurrent so that we can get some better information. Any questions around that rearrangement of our financial statements so that we can work out some ratios?

Cant see, Katy is fine. So I am going to assume people are sort of pretty happy there and move on to let's work out some of these financial benchmarks and ratios with our next slide.

So just try and keep with the current slide, with the current line rather than try and jump ahead. If you jump ahead we might miss some interesting important information about each particular line.

The first thing I will point out in terms of working out the financial ratios and benchmarks for this farm would be that there are four broad ratios that most [audio break] [0:23:57] to determine your overall health. The first one is liquidity and that basically means can you pay your bills when they fall due, and that's an expression we have used as we have been talking about cash flows etc. The second set of financial ratios have to do with efficiency - how well is the management of the farm turning inputs into outcomes, how well are you taking the costs and generating revenues if you like, how efficiently is that being done, is there wastage, could that improve. Third set of financial ratios have to do with profitability, how much profit are we making, are we making not enough profit, are we making too much profit compared to our peers and maybe in the short term that's okay, but in the long term not so good. What is the growth in our wealth and is it relevant for the risk that's actually been involved. So profitability are going to be some important ratios and lastly we look at debt and the flip side of debt is equity.

So have we borrowed too much, have we not borrowed enough, do we need to focus on repaying debt, or do we need to focus on being more efficient, or do we need to focus on generating better profit or do we need to focus on having enough cash to pay our bills when they fall due. So there is questions associated with each of these four broad categories, and we have got a sample of 11 ratios, there is a lot more than 11 financial benchmarks or ratios, we have tried to zero in on some of the main ones. And we have colour coded them in blue in terms of short term focus, red in terms of medium term and green in terms of long term. So [audio break] [0:25:49] ones today, but we will explain the red [audio break] [0:25:53] in Webinar 3 and the blue which will be discussed more in Webinar 4.

So by dividing current assets into or assets into current and noncurrent and our liabilities into current and noncurrent, we can now take our current assets and divide them by our current liabilities. So if you look at the balance sheet you will see S besides current assets and W beside current liabilities. So we got 156 as the things that will turn into cash in the next 12 months and 146 as things that need to be paid out in the next 12 months. So that difference between the two we call working capital.

And take away your current liabilities you end up with working capital which is ratio number 2 there, and in our case 156 minus 146 gives us $10,000. We will prefer our working capital not to be negative, thats we have more money going out in the next 12 months than we have got coming in, we would like it to be positive and in this case it is positive. But it is only $10,000 so it's not a significant positive amount, so I have got question mark beside whether that's a good figure or not because it depends on the time of the season that you are actually comparing.

Definitely at the end of the season, end of February perhaps you would want this to be positive, if you foresee some money come in and you have got all these payments coming out for the coming season. If its negative then you are going to have to have an overdraft to actually cover that. So it depends on the time of the season and I think a better indication of liquidity might be when we look at our cash flow budgets, because similarly we can divide our current assets by our current liabilities, S divided by W, and get a ratio. And for this sample farm its 1.1 and many people would say if its less than one then that's a bit of a typo it should be less than one, it's not good because you have got more liabilities than you have assets in the next 12 months and a lot of banks would like it more than one and half especially once you have received all your grain payments and that sort of thing come in.

But it depends when you are selling sheep, when you get paid that sort of a thing. So I think we better maybe reflect more on the cash flow when we get there than look too hard at liquidity ratios. Efficiency ratios are quite important, so we have got some here in terms of the amount of revenue we have generated, A from your profit and loss divided by the assets, our total assets in the balance sheet V. Another way to say this is for every dollar of asset how many cents of revenue are we generating, and in this case we are generating 22.9 cents.

We would obviously like this figure to be larger rather than smaller, and the broad benchmarks we have here are between 15 and 30 cents in the dollar. A lot of this will depend upon your enterprise mix, it will depend upon the value you have put on your plant and equipment, the value of your land. But all those assets you want to use efficiently to generate revenue and this is a bit of a measure of whether you are getting better or worse at that.

So we might - last year if we generated 25 cents in the dollar on our assets and this year only 22.9, and the season was similar and lots of other things were similar, we might go maybe we haven't used our assets as efficiently and we need to look at what can we do, could we maybe lease some land to someone rather than farm it ourselves, could we maybe do some contract harvesting if our plant and equipment is not being used efficiently.

Could we change our plan with our sheep, such that those assets are generating more revenue rather than less revenue. So I have given this one a tick for our model farm because it's in that sort of ratio and towards the middle, I would like to know what it was last year before I got too comfortable with that. We also have an input ratio where we take our variable costs B from our profit and loss and divide them by our revenue. So another way of saying this is for every dollar of revenue how many variable costs how much were our variable costs, and in this case it was 37.5 cents.

These are the livestock and the cropping costs, those that we can directly relate with each enterprise. And whilst the margin here, we would like this to be lower rather than higher and that would be a good sign of efficiency if we can get a better yield using the same inputs. If we can earn more revenue from our sheep using the same costs to produce those sheep. So it's a measure of our operating efficiency and the broad guidelines here are quite broad, 25 to 40 depends on your enterprise mix. The fact that its towards the top end I have put a bit of a question mark there because it might be a negative trend, you know we went 30, 35, 37.5. And if there is no other reason for that happening and we are not changing our enterprise mix and the seasons arent that much different, then maybe that's a bad trend. So I would like to ask a few more questions about that ratio to see whether I am happy with it or not.

Operating profit ratio, we take out earnings before interest and tax, our operating profit, and we divide it by our revenue. So after we take off our variable costs and our overheads, how many cents in the dollar is left. Similar ratio to the input cost, but this includes overheads. And the same 27.5 here which is once again towards the top end, but a lot of thats being caused by the variable costs not so much the overheads because its this one is very close input cost ratios towards the top end. And our operating costs is towards the stronger end actually, so we have actually probably got quite good overheads because it has taken us from the bottom end of this range to the top end here, when we take our overheads away from our gross margin to get our operating profit.

Then we go right down to the bottom and we take our net profit ratio before we take off our tax and drawings and we divide it by our revenue and in this case we have got 18% which is less than the bottom end of this range. So I have got a cross beside that one.

So the difference between our operating profit ratio and our net profit ratio is our finance costs. So we take our finance costs away from operating profit to get our net profit before tax G. So I would think here that there is a problem and an issue in that we are paying a lot of interests and maybe a lot of lease payments, and we need to try and focus on reducing that because we are underneath the bottom end here.

So lets look at the longer-term ratios and then well have a bit of a break so you can stretch your legs etc. Plant to gross income, so the value of your plant compared to the revenue its helping you generate. So U is your plant and A is your revenue and the ratio here is saying look it would be nice to be more than one to one and actually you don't want to be more than one to one, thats a lot of plant and not much revenue. And if you are using your plant efficiently, maybe it's going to be less than 0.8.

I guess this ratio could be too low as well in terms of if it's you haven't invested in your plant and equipment, this ratio might look quite good, but it might be holding back your revenue. The other ratios are suggesting that maybe if I had more revenue, the net profit ratio wouldn't be as bad. So maybe there is an issue in it, that might be too low. So we have got to ask some questions once we see these ratios.

Return on assets is about we take G and if we flip back up, we can see G is our net profit before tax and we divide it by our total assets. In this case our return on assets is 4.1, and the range we are talking about here is between 2.5 and 5. This is a good ratio for this sample farm, its within the range, its also something you can use in terms of should I be borrowing money to invest in the farm, should I get into more debt? And my answer here would be no. Unless you can borrow the money at less than 4.1%, then why would you borrow money at 6% to buy some new plant equipment when the return is only going to be 4.1 on average. So you need to be very careful about making that decision that you are not actually borrowing money at 6.0 and getting return of 4.1 on the asset you have bought. You are losing money 1.9.

Now there is a few more things you need to consider in terms of buying plant, but return on assets is a good one to compare to your interest rate, to sort of say, is it worthwhile borrowing money or should I be using some of my profit to make that investment rather than borrowing from the bank or maybe 50:50 because if I bought that plant and equipment with half my own money from the farm and half from the bank, then the effective interest rate instead of 6.0 is now 3%. Now it makes a bit more sense if I can generate a return of 4.1 on something thats costing me 3.0, I am making 1.1% on that investment.

Return on equity is a measure of profitability before by comparing it to how much equity we have. For each dollar we have got invested in the farm, how many cents are we making? This is an important ratio to compare to other investment options. So its also an important ratio to compare to risk. So this farm is making 5.5 which is above the strong range so thats a positive ratio. If I have the opportunity to invest in a business in town, if I looked at how much I was investing and what profit it should make and divided the profit into what I am investing, I would get a return on equity on that other investment.

So it might be useful to actually compare that to what if I invested that money in the farm? What sort of return would I get? If I can then align the risk of the two different investment options, look at the returns that its actually giving me, then I am in a better position to make a decision whether to make that off farm investment or whether I should use that money maybe to reduce debt. Because if I can reduce debt that I am paying 6% on, then that might be a good option when this off farm investment is only generating a 4% return on equity. So good for comparing investments and aligning your decisions to risk return on equity.

The final two ratios around debt, equity to assets, how much of the farm do we own? Are you interested in this one because their security is largely tied up in the assets of the farm, more particularly its tied up in the land and buildings on the farm. The current assets tend not to be taken into account that much by the bank and the plant and equipment, they sort of write down quite a degree. So they are really looking at the value of the land against how much loans you have. From a business perspective we can look at how much you own of your total assets and the ratio here is saying somewhere between 70 and 90 would be a good range and the higher the better.

At this point we are towards the low end 76% so there is not a lot of safety margin there at the valuation in the land, a poor season, and we need to borrow money to keep going, its not giving as much safety margin to actually invest in the business. So was this acceptable, may be would be happier between 80 and 90 rather than at 76. So we are going to look at that one a little bit more closely and here is the key one that the banks look at. They take your E which is your operating profit which is earnings before interest and tax and they divide by your F which is your finance costs.

So to a degree of safety margin how many times is your earnings before interest and tax, how many times does it cover your finance costs? And in this case its 2.9 times, banks would say, you know, we wanted three times or more but for operating your business somewhere between one and two is the closer to two would be better. So thats above two, so thats a positive. So if I was to look at all these sort of figures in terms of strengths and weaknesses, I would say there is a bit of an issue potentially around finance costs or potentially its around the revenue and if we got more revenue and make more profit, the finance costs would look a lot better and that might have to do with our investment on plants and equipment it might be holding back our potential to generate revenue. Even though our revenue to assets was okay, its at the lower end. So maybe that revenue to assets figure could improve if we can generate more revenue from our existing assets and that might involve investing in some assets to generate that more revenue and if we do that then potentially our net profit ratio could improve.

We seem to have some capacity down here if we do need to borrow some more money to make that happen. Our interest coverage is quite good and there is a little bit of margin there as well. So a bit of an overview in terms of looking at the farm from a financial health perspective and a financial benchmarking perspective.

So why dont we have a bit of think about that and the balance of the webinar is going to be taking some of those ratios especially the green ones and saying what sort of decisions can we make based on that. So have a think about it, any questions you have I will ask for those, you can type them in during the break and we will get back under way in five minutes.

Okay, so lets get back under way, question from Sarah there, in your balance sheet where do you get the figure for the overdraft? Its a bit like how you pronounce certain words, I say potato, you say potato, tomato, tomato. Some people put it under current assets because cash in the bank is an asset, some people put it under current liabilities because if you are overdrawn its a liability. So in our current assets, if you have overdrawn its going to be a negative figure, its going to be in brackets. If you put it in your current liabilities and its overdrawn its not going to be negative because its a liability, its money you owe. If its a positive balance in the current liabilities its going to be there as a negative, its going to have brackets around it if you put it in your current liabilities. So make a choice one way or the other. I would tend to put it in my current assets in the hope that I have got money in the bank and then when I see it as a negative I know that its actually overdrawn rather than put it in the current liabilities. So that would be my sort of suggestion, depends how you have set up your accounts, though, in terms of Agrimaster or any other financial programs you are using.

Should you use the up and coming cash flow that is the coming years figures or your last years cash flow figures? So far we havent looked at cash flow because all our figures for our financial health has been taken from last years profit and loss and balance sheet. So we havent drawn any figures from the cash flow. At the start of the year you are going to have a cash figure which is the end balance of last years cash flow. If thats the question you are asking, I would suggest that the coming years cash flow is good for determining your liquidity rather than maybe using some of those earlier figures that is the liquidity figures, the working capital figures. I would tend to use the coming years cash flow as a better indication of whether I can pay my bills on time or not.

Thank you, Sarah, good questions, well done. So lets take some of these financial ratios and start to say well how can we use them to make better decisions?

So there is a few things we need to be aware of as we use any benchmarks and financial ones are no different is the consistency of the measure. Are other people using the same formula as us? Are they calculating the data the same way? Sometimes there may not be comparisons available, you may want to compare certain ratios and you cant find them and, indeed, you might just get an average or a broad range where you want to find what are the best farms doing rather than whats the average farm doing. So the benchmarks are often sort of averages, we prefer to be more towards the top end than the bottom end and understanding what the top 25% of farmers are doing rather than the bottom 25.

Ratios can be impacted by the scale of your operations, so bigger farms can spread their overheads across more revenue, so that makes some of their ratios a bit more attractive because of the size of the farm. So it can vary where you sit in those ranges based on the size of your farm, obviously good, bad, average seasons are going to have a big impact, the time of the year and whether you are about to sell some sheep or you are about to sell some wool or some other timing issue creates a difference, so we need to be careful of that. Definitely if we are comparing from year-to-year we want to compare at the same time each year. And the fact that these averages and ratios and benchmarks are not your farm, they dont have your enterprise mix, they dont have your goals, they dont have your farming conditions, they dont have your history. So very difficult to compare if you have got significant differences in any one of those issues.

Having said all that, I would rather have an understanding of where I sit rather than not. It then becomes what can I do to use benchmarks more effectively to make better decisions and I think there is a range of things that many people do. Many people use a trend over time and whether we are getting better or worse rather than absolute figures. Many people average ratios over a period of time to take out the impact of seasonal variations. So that can be a good approach. If you can get ratios that are for your farming area and region that might be more appropriate and relevant to compare yourself against. We definitely want to align our results to what are we trying to achieve with our business plan and our overall goals. And its really via continuous improvement rather than, you know, where exactly the exact figure, if we are getting better over time then thats the result we are sort of aiming for.

So let us focus on trends and improvements and keeping a track record and a history of our results and ratios and numbers arent the total answer. They might be the starting point for a discussion so it might identify a problem that you can talk through and work out a solution, it may not give you a solution and, indeed, when you examine it further it may not even be a problem.

We need to use other financial information in addition to our own. Also this might be around our cash flow and our cost of production, we want to benchmark against ourselves as much as or even more so than others. And that might be the most accurate way to benchmark, how we go or how we are going, how are we improving in the medium term to long term because there might be some short term fluctuations, but are we getting better in the medium to long term.

So given that, its still worthwhile to have some financial objectives and goals that we are aiming for and it will help us in terms of answering some very broad long term decisions about how we sustainably grow our wealth, how do we improve that equity over the next 3 to 10 years?

What are some of the decisions we need to make, how much profit should we re-invest in the farm, how much should we take out for living expenses or beyond living expenses as a reward for all the efforts and risk that we have taken? So what do we do with that net profit at the bottom there, because we have got two options, we can leave it in the business to help it grow or we can take it out of the business in the form of dividends? And we could invest it for our retirement; we could do lots of things, if we leave it in the business we could buy more assets, we could pay off debts, we can do lots of things with it.

In terms of those investments options or re-investment options, when we take that profit we might look at things like super, farm management deposits, buying new plant, upgrading existing plant, reducing debt, leasing or buying more land, maybe an off farm investment, maybe improving our working capital so we dont have to use the overdraft for the coming year, maybe building a bit of a contingency fund against a poor season.

So these are important decisions to make and we need to make short term decisions that align with our long term goals. And if you think about it, how you make those decisions is going to be depended upon your risk profile, your preferences, your situation, but its also going to be very dependent upon the lifecycle of your farm.

So what do I mean by the life cycle of the farm, if we look at a farm over its life then this might typically categorize some of the stages it goes through. If you consider time down the bottom in years and it might be over the total of the graph, it might be 20 years sort of time horizon or longer. And if you look at the vertical axis and we consider that as maybe your equity to assets ratio, what percentage of the farm do you own? Remember in the previous slide we are talking between 70% and 90%, so 70% would be towards the bottom here and 90% would be towards the top there. So we are suggesting that if you dont own a lot of the farm and you are back towards the 70%, you are in the emerging stage and your focus is about trying to grow the equity in the business to reduce your financial risk.

Having invested in the farm and grown your wealth then you enter a period of consolidating that wealth. Through consolidation and you get more into levelling off of your equity to assets ratio and you are getting a bit more comfortable, you have got the debt under control, you have invested in plant and equipment, you are generating reasonable profits fairly consistently, you are in that maturity stage and you are questioning whether to invest in the business or not especially as you lead towards retirement depending upon what your retirement plans actually are.

So really what we are doing here is putting the lifecycle of the farm against the percentage of the farm you actually own and trying to build that percentage over time because that is sustainably growing your long term wealth. And many of your goals fit within that broad financial goal as a long term financial objective.

So lets look at each one of these stages separately and some of the decisions that you can or should be making within that stage. So we are going to look at emerging and growing together because often the decisions you make are fairly similar, when you are in the early stages and there is a high financial risk because your equity is quite low. The focus is obviously on building equity so lets look at how we build our financial equity within our next slide.

One thing we can focus on obviously is to be very efficient that input cost ratio that we looked at, how can we get more revenue for the same amount of inputs? Or if we improved our inputs a bit, would we get an even bigger return in terms of revenue? So is it worth buying some extra fertilizer to get an extra yield in terms of a crop? Is it worth holding on to those sheep and getting some another, cut, clip I think of wool before we actually sell them? What can we do to improve our productivity in the short term is going to generate more profit and that will help us invest in the business to help it reduce its, improve its equity position. So we can focus on our mix, our efficiency, our profit and loss and these mid to short term decisions that impact on those.

We can try and grow the scale of the farm is another focus at this point in time as we are trying to improve our equity. And I guess there are a few options here; we could look at things like increasing our flock size if thats going to help our revenue to asset ratio. So a decision here is by investing and growing the scale, is the return in terms of revenue going to be worth it and that revenue to asset ratio can help us. Maybe we could buy some extra lands somehow if we have the financial capacity to do so or if not maybe we could lease some. Bearing in mind we are in quite low equity levels maybe leasing is a better option. Share farming, some other sort of option to try and improve the scale of what we are actually doing increase the size of things. And the third thing we can focus on in this emerging and growing stage, the early stages is we could look at investing in capital and maybe plant especially if that investment, the returns are more than the costs.

So we have got to keep the cost down at this point in time, so this is about the extra equipment more than the extra costs. So its important decision, we will examine this a bit further in a little while, but maybe at this stage rather than new equipment we are looking at second hand equipment. Maybe we cant afford that capital investment and we need to get a contractor in for certain tasks and jobs because we have increased our scale, but we cant afford the capital investment.

And while we are doing all three of these things we are trying to keep a very tight watch on our cash flows. And maybe people even try to minimize their drawings to reduce that cash out flow on the business to leave money in the business. Importantly see that as an investment in the business, the money you didnt take out is you investing money back into the business for you to be able to get access to that money in the future.

So some key focuses, if you are at the early stages there, what about if you are more at the consolidation stage which is our next slide?

What are some of the key decisions that we can make here, one, because more freely on that buying assets because our equity has built up a bit and we have some capacity to actually buy. We could invest in property and yards, we could invest in machinery, especially if our return on assets is going to be more than that interest rate, that point we talked about before. A strong focus here might also be around reducing your debt further to get more towards that maturity stage and build a greater safety margin.

Reduce your interest risk expense, reduce the risk and improve your borrowing capacity just in case there is a need to borrow money down the track due to a poor season or a major breakdown, that sort of thing or change in operations and maybe a significant increase in the flock size for example or an upgrade of your yards. And the third thing we can do is maybe invest some of that money back into the business and we could use this to upgrade plant and equipment. We could look at new opportunities that we havent taken on before within the farm or maybe outside of the farm.

We want to make sure that profits are not suffering from a lack of investment in our plant and equipment because we were quite tied on that as we were in that emerging and growing stage. So I just want to zero in a bit on this issue of sort of investing in plant and equipment and look at some key sort of questions that you might need to ask yourself as you are considering buying plant or equipment. And there is the questions there, you can read them as well as I, having to think about that.

So some good questions there and from a financial perspective how might we sort of answer those. When should we buy and not buy a new plant or equipment? We should buy it when the returns outweigh the costs, the extra money that we get and the profit that we make from that plant and equipment is more than the extra costs. And to do that maybe we need to look at ways to optimize use of that equipment and not have it idle for any excessive amounts of time. So multi use sort of equipment or contracting out equipment and earning money that way. So the key thing here is looking at the benefits outweigh the costs.

And what we are looking at here, when we consider the costs and the benefits is the full cost of ownership not just the operating costs, we are looking at the extra costs compared to what we are currently doing. So if we are upgrading plant, the extra cost, if the operating costs are the same between the new plant and the old one then there is no extra cost in getting that new plant. So we are looking at the incremental not the total. But we are looking at the full costs not just some of the costs. In fact, if the new plant and equipment is more efficient and going to save on fuel and be more efficient in its use of resources then that is actually a benefit in getting that new plant.

So that is like revenue, its a reduction in your costs so that could be a benefit to consider in terms of weighing up against the costs. So we look at extra, additional, incremental, depreciation, interests, insurance and rego all of the different costs involved not just some of the costs but look at the incremental not the total.

Which plant and equipment should you select? Well this is going to vary from farm to farm, you know, what aligns to your business plan, what are your strengths and weaknesses and what are you trying to address from that financial health check you did? What does your budget allow you to do, when did you last upgrade, what is the ease of use and functionality and the safety issues with that equipment? How well and quickly could a breakdown be dealt with, so there are lots of non-financial considerations in terms of buying plant and equipment that you need to take onboard? But if you want to take on the financial considerations and prioritize between different options, one thing you could do is take all the costs of ownership and divide by the benefits of ownership.

So how much is this new plant and equipment going to cost and then how quickly will the benefit cost, this is called a payback period. And if you do this for several different options, you know, I could upgrade my yards, I could invest in more technology for my sheep, I could increase my flock size, all of these are investments. I could buy a new header, all of these are investments, if we take the total costs and then divide that by the benefits each year that its going to derive then that will be of something good.

And the shorter the payback period the better and that might be useful rule of thumb in terms of selecting between different options that you have in terms of investing in plant and equipment. So that was really at the consolidation stage, as we move in to maturity and looking towards retirement. Now focus has to move to more things like clearing of debt maybe a greater consideration of off-farm investments which might help us in our retirement and definitely things around tax management, averaging of your profit, farm management deposits, superannuation, your accountants and financial advisors will be able to give you better advice around that.

But at this stage you are at a degree of comfort and you may not be looking to invest in the business and take the risks associated with that to generate more profits. It probably depends a fair bit on your transition plan and your risk profile and your personal preferences. Are you handing the farm over to the next generation, are you going to lease it out, are you going to try and sell it? That will impact some of the decisions you make towards that end of your lifecycle. And in the end what you are actually doing is trying to decide what to do with that discretionary income, hopefully that you have at the bottom of your profit and loss.

Once you take out your drawings, you have paid all your interests and you have paid all the variable costs and all the overheads, that bit at the bottom, what am I doing with that? And here is how one farmer has actually addressed that and have come up with a range of different options to spend that discretionary cash. And the first one sort of says put some off the term debt and the next chunk of money between 21 and 40 would be used to upgrade plant. And then the next chunk, what I like about this mix is that there is elements in here that make it sustainable.

If you never take any money out of the farm to enjoy the benefits of having a good year, a performance bonus for example, will take a special holiday if you have done really well then it becomes very much a grind. So if at all possible we need to build some sustainability by saying, Well lets celebrate our success to a degree and balance that with the need to invest in the business to continue our growth of wealth in the long term. Now your mix of what you do with your money and discretionary spend is going to be up to you. Maybe you dont need to break it down into 20, 30, 40 grand lots, maybe you do in 50s, maybe you have different priorities based on the lifecycle of your farm and your risk profile. But thats your decision and its a decision that people involved in the running of the farm need to make jointly. Its not just the people in charge of the books, its everyone involved in the running of the farm and setting that objective will help you make short term decisions that drive you towards your long term outcomes.

There are some references for what we have actually talked about today and the linkages are there and a bit of a description of each one as well that might help you in terms of any other specific information we have spoken about.

Let me just get back to, up here to wrap up in terms of a summary of the things we have spoken about and as I am summarizing any sort of key questions you might have or key learnings from the session or feedback on the session, I am going to ask for that in a minute, so have a listen to a bit of summary and try and give me some feedback as to any key take outs, feedback on the session etc.

What we have started with was re-arranging our profit and loss and our balance sheet into different sub-headings and headings so that we can make more sense of the information thats actually there. And this allowed us to produce some financial ratios and compare them to some bench marks. Now whilst these ratios have some limitations, it would better to have them than not and maybe we need to compare them with ourselves as well as others and see the trends over time whether we are getting better or worse, so building up this history over the life of the farm. In terms of making decisions to improve your long term wealth, these are long term decisions and they are depended upon, to a degree, the life cycle of the farm.

Think about where your life cycle is at and this will be a financial consideration in the decisions you make. And those decisions might be around debt, investment in plant and equipment, buying more land or leasing more land, spending money on yourself, minimizing tax, preparing for retirement, depending on what life cycle you are at, importantly get all the different stakeholders on the farm involved in understanding what those longer terms decisions are, occasions of those decisions.

So thats a bit of a summary of what we have spoken about today, thank very much guys, I will wrap everything up there, talk to you later.

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