Many decisions in agriculture are taken without clear knowledge of what the specific outcome will be, often leading to less than perfect results.
Crop farmers, for example, are often faced with decisions about which crop to plant, the amount of fertiliser they should apply and other inputs they should use. These decisions are made before knowing what the ultimate crop yields will be and what prices these crops will fetch. Similarly, cattle farmers who decide to expand their enterprise may have to wait several years before they can receive income from calves, for example.
These examples paint a clear picture of how risk is inherent in agriculture and how complex its management is. Risk comes from unexpected outcomes, often with serious financial implications, and managing it is largely about reducing the possibility of unfavourable outcomes, or at least mitigating its effects on the business.
It is important to understand that for any business, good risk management does not necessarily mean the total elimination of risk. Rather, it means containing the risk at a level that the business is willing and able to bear. Good risk management requires a hands-on approach that integrates all the business functions of the farm.
Risk management strategies
When dealing with risk, there is no straightforward approach. It is important that farm businesses are as flexible as possible for risk management strategies to be successful. Various strategies, such as enterprise diversification, vertical integration, production and marketing contracts and insurance products, are available.
However, farm businesses are not all the same and there cannot be a blanket solution to their risk exposure. Financial position, the size and type of the farm business and various other factors play a huge role in determining the enterprise’s ability to shoulder risk.
A well-established farm business with a large amount of equity capital, can afford not to insure as it is able to withstand larger losses before it feels the total impact, while a smaller enterprise that has just started production cannot afford to forego the option to take out insurance, should the unforeseen occur.
The farmer’s use and choice of debt to finance operations depend on many factors, which include the level of risk aversion, size and type of the operation, and the performance and positioning of the business within the market. In general, a highly leveraged farm business has greater financial risk than a farm business that operates in a less leveraged financial structure.
Highly leveraged farms whose debt exceeds their assets can lose equity. These businesses will be more exposed to financial risks, such as those related to high interest rates. In such cases it is often advisable for farm businesses not to borrow capital, or at least to wait until their position improves.
A healthy cashflow is also very important for risk management. Farmers with high living expenses will be less able to withstand a low-income year, and it is important that farm businesses maintain their liquidity by taking care of short-term liabilities. A dent in the business cashflow because of technical or market factors, can have an impact on farming income.
Assessment, analysis, application
It is important that farm business managers study the different types of risk as well as their impact. They should identify the mitigation strategies available for each type of risk and prioritise it according to the potential impact on the business.
To assess and analyse risk, business managers must be able to formulate probabilities and analyse a wide range of potential outcomes for different decisions. These probabilities are useful for forming expectations. The true probabilities are seldom known but are always subjective, e.g. rainfall probability.
Farm businesses differ, and the interpretation of available information will vary from business to business. Once all probabilities and their outcomes have been formulated and weighed against each other, a suitable decision can be taken and implemented.
Risk management starts with decisions taken on the ground, such as which output to produce and which inputs to use for production. Businesses must arrange risks according to their impact (minimal to disastrous) and the probability (improbable to highly probable) that these risks will occur.
By evaluating each possible risk according to the above criteria, a producer will be able to discern between risks that require immediate attention and those that are less important. The risk remaining after all risk mitigation has been implemented is known as residual risk. This is the risk the business simply must cope with in flexible and strategic ways.
There is no generic risk management strategy that works for everyone, and the same strategy cannot be used for every season. It is important that businesses consider their own risk appetite and tailor their strategies for maximum benefit.
For more information contact 011 721 9089, or send an email to SBSA.email@example.com. You can also visit the website at www.standardbank.co.za/business