Developing a Profit-Risk Decile Calculator to Capture Farm Risk

Developing a profit-risk decile calculator to capture farm risk

Jackie Ouzman1,4, Therese McBeath1, Michael Moodie2, Ed Hunt3, Marta Monjardino1

1 CSIRO Agriculture Flagship, Glen Osmond 5064 SA 2 Mallee Sustainable Farming, Mildura, 3502 Victoria 3 Ed Hunt Consulting, Wharminda, 5603 SA 4 Presenting author, email: [email protected]

Abstract In dryland farming systems, farmers who increase their cropping intensity, tend to increase their downside risk. Consequently, farmers are increasingly exposed to financial and income risk due to additional costs of capital adjustment and increasing levels of enterprise debt. To help farmers analyse farm management decision across the growing season rainfall deciles, a farm-scale profit-risk decile calculator has been developed. A key feature of the profit-risk decile calculator is the ability to compare alternative strategies using a range of financial and economic measures in the same analysis. Site-specific versions of this calculator have been developed using workshop-based consultation between farmers, advisers and researchers for two regions in South Australia. We present a case-study farm developed for Cummins on the Lower Eyre Peninsula, South Australia to demonstrate the capability of the tool. We provide an overview of how the profit-risk decile calculator was developed, including input requirements, outputs generated and an interpretation of results. Using an example of high versus moderate nitrogen (N) management intensity, we demonstrate how farm risk can be explored for a range of outputs; either for a single calendar or rainfall decile year, or after a five-year run of seasons. The aim of this tool is to account for both production risk and business strength such that farmers and their advisors will make better informed decisions despite increased intensity and complexity of farming.

Key words Profit – risk, decision support, Lower Eyre Peninsula, N management Introduction Assessing the merits of a new farming strategy can be challenging. Many farming decisions are based on projected profits in an average year. However, often maximising profit for an average year will not reduce risk, and understanding the trade-offs between profit and risk is complex (Monjardino et al. 2013; 2015). Risk varies with the climate, soil type, farm enterprise mix, commodities and input prices and the level of individual risk- aversion (Harwood et al.1999). A study of the perceptions of risk of Eyre Peninsula farmers ranked climatic variability as the most important source of risk, followed by financial risk and government policy (Nguyen et al. 2007). Farmers can manage risk by reducing variability, transferring risk or building the farm’s capacity to deal with risk. Strategies are varied and include enterprise or geographical diversification, maintaining financial reserves and leveraging, leasing land or machinery, increasing liquidity, crop insurance, generating off-farm income, adjusting farm input, or changing farming practices (Harwood et al.1999). However, these strategies cannot be successfully evaluated without a careful analysis of the potential impacts on farm business performance. Therefore, a tool that allows individual farmers to explore these trade-offs is potentially useful. As climate is the key driver of crop production, and farmers perceive this risk to be the greatest. The calculator uses rainfall deciles and resulting yield responses as the primary driver for assessing business risk. The profit-risk decile calculator allows for comparison between current farm operations and alternative management strategies to examine how it may perform over a range of rainfall deciles.

The profit-risk decile calculator was developed with the aim of utilising the outputs of complex bio- economic modelling (Monjardino et al. 2013; 2015) in a format that farmers and advisers could more easily manipulate. The calculator requires farm-based data, and in this case it was generated through an iterative process involving researchers, farmers and consultants in a series of small workshops. This lead to the creation of case-study farm which enabled advisers and farmers to complete comparative scenario analysis, and in this paper we compare different N management strategies at the farm scale.

Methods The profit-risk decile calculator requires inputs of seasonal crop production including local rainfall deciles (prefilled for the users), crop area according to soil type, enterprise mix, fixed and variable costs, farm ownership, farm assets, as well as crop yield associated with a given soil type, management strategy and rainfall decile (Figure 1). The input data was generated in workshop settings to develop a local case-study farm

Methods

The profit-risk decile calculator requires inputs of seasonal crop production including local rainfall deciles (prefilled for the users), crop area according to soil type, enterprise mix, fixed and variable costs, farm ownership, farm assets, as well as crop yield associated with a given soil type, management strategy and rainfall decile (Figure 1). The input data was generated in workshop settings to develop a local case-study which can then be tailored by the individual post-workshop. Rainfall deciles were calculated using 56 years of farm which can then be tailored by the individual post-workshop. Rainfall deciles were calculated using 56 yearsdaily ofweather daily weather data, with data, rainfall with rainfallthe sum the of sumgrowing of growing season seasonrainfall rainfall (April (Aprilto October) to October) plus 25% plus of 25% the of fallow therainfall fallow (as rainfall is the case(as is for the water case foruse waterefficiency use efficiency calculations). calculations). The years The within years a withingiven rainfalla given decilerainfall are listed deciletogether are in listed the calculatortogether in as the analogue calculator years. as analogue The profit-risk years. The decile profit calculator-risk decile outputs calculator are grouped outputs areby whole-farm groupedeconomics by wholeand finance-farm economics measures. andEconomic finance measures.measures include Economic profit measures and loss, include earnings profit before and loss,interest and tax earnings(EBIT), andbefore farm interest net profit and tax before (EBIT), tax and(FNP). farm Farm net profitfinance before measur taxes (FNP) include. F armnet worth,finance equity, measures return include on capital netand worth, cash flow. equity ,The return results on capitalcan be aviewednd cash either flow .for The a singleresults calendar, can be viewed rainfall either decile for year, a single or after calendar five-year, run rainfallof seasons decile which year, are or aafter historical five-year sequence run of seasonsor user selectedwhich are sequence a historical of seasons. sequence or user selected sequence of seasons. Seasonal Production

Rainfall Deciles Resource Condition

Case-‐Study FarmData* Soil Types Profit-‐Risk * Crop area, yields & prices N & P Farm Economics (Profit & Farm Finance * Input rates & costs Management Loss, Cash Flow) (Balance Sheet) * Farm ownership, Strategies assets & value

FigureFigure 1 1 data data requirements requirements and and outputs outputs for for the the ‘cash ‘cash flow flow calculator’ calculator’ This paper uses a Cummins case-study farm to illustrate features of the profit-risk decile calculator. Two This paper uses a Cummins case-study farm to illustrate features of the profit-risk decile calculator. Two profit-risk workshops were held at Cummins with local farmers, consultants and researchers to establish profit-risk workshops were held at Cummins with local farmers, consultants and researchers to establish casecase-study-study farms farms that that reflect reflect the the local local conditions. conditions. Cummins Cummins is located is located on the on Lower the Lower Eyre PeninsulaEyre Peninsula (-34.26, (-34.26, 135.73)135.73) with with average average annual annual rainfall rainfall of of400 400 mm. mm. The The key key attributes attributes of the of casethe case-study-study were were:: • 1400• 1400 ha farm ha farm valued valued at $7,000/ha at $7,000/ha • Manager• Manager allowance allowance of $50,000of $50,000 and and staff staff wages wages of of $51,500/year $51,500/year • An• overdraftAn overdraft of -$2,000,000 of -$2,000,000 • Plant• Plant and andmachinery machinery inventory inventory value value of of$1,120,000 $1,120,000 • Total• Total fixed fixed costs cost ofs of$96,750/year $96,750/year • Two• Two soil soiltypes, types, clay clay (75% (75% of croppedof cropped area) area) and and waterlogging waterlogging clay clay (25% (25% of of cropped cropped area)area)

TheThe casecase-study-study farm farm at at C Cumminsummins wa wass used used to to compare compare two two levels levels of ofN Nmanagement management intensity intensity:: a high a high intensity intensityscenario scenariowhere 700 where ha wheat 700 ha and wheat 700 and ha canola700 ha werecanola cropped were cropped with applications with applications of 100-300 of 100 kg-300 urea/ha kg and a umoderaterea/ha and intensity a moderate scenario intensity which scenario has 700 which ha wheat, has 700 350 ha hawheat, canola 350 and ha 350canola ha andbeans 350 with ha beans100-300 with kg 100 urea/ha- 300applied kg u torea/ha the wheatapplied and to thecanola wheat only. and canola only.

TableTable 11.. YieldYield (t/ha) (t/ha) in in response response to to N Nmanagement management and and season season type type for forCummins Cummins case case-study-study farm farm.. Yields Yields were were developeddeveloped using using farm farm records, records, local local trial trial data data and and APSIM APSIM outputs. outputs. High N Management Intensity Moderate N Management Intensity High N Management Intensity Moderate N Management Intensity Decile Decile 1 Decile 1 Decile 3 Decile 3 Decile 5 Decile 5 Decile 7 Decile 7 9 DecileDecile 9 1 DecileDecile 3 1 Decile Decile 5 3Decile Decile 7 Decile 5 Decile 9 7 Decile 9 Wheat Yields (50% of farm area) Wheat Yields (50% of farm area) Wheat Yields (50% of farm area) Wheat Yields (50% of farm area) Clay Clay 2.4 2.4 2.9 2.9 3.4 3.4 4.5 4.55 52.7 2.73.2 3.83.2 5 3.8 5.5 5 5.5 Waterlogging Waterlogging Clay Clay 2.4 2.4 2.9 2.9 3.4 3.4 4.5 4.54.1 4.12.7 2.73.2 3.83.2 5 3.8 4.5 5 4.5 Fertiliser Fertiliser Input Input (kg (kg Urea) 100100 140 140 180 180250 250275 275100 100140 180140 250180 250-‐250300 250- Urea) 300 © 2015 "Building Productive, DiverseCanola and Yields Sustain (50%able Landscapes of farm "area) Canola Yields (25% of farm area) 2 Proceedings of the 17th ASA Conference, 20 – 24 September 2015, Hobart, Australia. Web site www.agronomy2015.com.au Clay 0.9 1.3 1.6 2 2.2 1 1.4 1.8 2.2 2.4 Waterlogging Clay 0.9 1.3 1.6 1.6 1.6 1 1.4 1.8 1.8 1.8 Fertiliser Input (kg 140 180 240 275 300 140 180 240 275 300 Urea) Bean Yields (25% of farm area) Clay 1.4 1.8 2.5 3.0 3.0 Waterlogging Clay 1.4 1.8 2.5 3.0 1.8

© 2015 “Building Productive, Diverse and Sustainable Landscapes “ Proceedings of the 17th ASA Conference, 20 – 24 September 2015, Hobart, Australia. Web site www.agronomy2015.com.au Yields varied according to N management, soil type and season (Table 1). The yields used in the Cummins case-study farm were based on a consensus of local trial data (in this case N management trials), APSIM modelled response to N management and historical farm data. Yields have been adjusted for the management scenario, such that the high N intensity has approximately 10% less yield despite equivalent N input (an outcome which appears sensible based on yield measurements available and estimates of the potential benefit derived from having a legume in the sequence).

Results and Discussion The profit-risk decile calculator outputs economic measures indicating the financial performance of whole- farm business. Generally a higher EBIT indicates better business performance, the calculator compares how EBIT behaves in a average year versus low or high rainfall years, thus adding value to reviewing the farm business performance. The moderate intensity scenario is earning $124 K more than the high intensity scenario in a decile 5, increasing to $148 K in a decile-7 (Table 2). FNP follows a similar pattern, increased from decile 1 through to decile-7, but there was only a small increase from decile 7 to decile 9 due to the effect of waterlogging on yield (Table 2). The difference in FNP between management scenarios was greatest in a decile-7 year, with the moderate intensity scenario generating $151 K more FNP than the high intensity scenario. Cash flow is a measure of liquidity, a positive cash flow indicates that financial obligations are met, this is especially important in low rainfall/yield years (decile 1-3). Both management scenarios started with a -$2000 K overdraft. After one year the cash flow was negative with a decile-1 year; however all other rainfall seasons (decile-3 to 9) showed improved closing balances with the moderate intensity scenario $78-110 K ahead (Table 2). Net worth and equity both reflect how the farm business is performing after a single year. In both scenarios equity was greater than 80% and net worth had growth in decile 3 through to decile 9 (Table 2). Again the moderate intensity scenario performed better across all deciles.

Table 2. Profit-risk decile calculator outputs comparing the high and moderate N management intensity scenarios on the Cummins case-study farm after one year. Decile Start Decile 1 Decile 3 Decile 5 Decile 7 Decile 9 High N Intensity aEarnings Before Interest, Leasing and $95k $258k $413k $645k $705k Tax (EBIT) bFarm Net Profit Before Tax (FNP) -$211k -$46k $111k $346k $408k cCash Flow (Expected balance at bank) -$2,000k -$2,104k -$1,939k -$1,782k -$1,547k -$1,485k dNet Worth $8,920k $8,709k $8,874k $9,031k $9,266k $9,328k eEquity 81% 82% 84% 86% 86% Moderate N Intensity Earnings Before Interest, Leasing and $175k $334k $537k $792k $812k Tax (EBIT) Farm Net Profit Before Tax (FNP) -$129k $32k $238k $497k $517k Cash Flow (Expected balance at bank) -$2,000k -$2,022k -$1,861k -$1,655k -$1,396k -$1,376k Net Worth $8,920k $8,791k $8,952k $9,158k $9,417k $9,437k Equity 81% 83% 85% 87% 87% aEBIT = sum of gross margins - overheads, bFNP = EBIT – depreciation - interest, cCash Flow = FNP - principal repayments -allowance for machinery or cash purchase, dNet Worth = total assets - total liabilities, eEquity = net worth/ total assets.

Measuring farm performance over a range of season types is beneficial, as it shows the resilience of the farm over time and the ability to recover from a financial shock.This is valuable for developing the ‘big picture’ in scenario analysis and shows how discounted cash flow, equity and net worth are expected to perform over time. In the case study, a run of historical years starting in 2002 and finishing in 2006 corresponding to decile 2, 7, 4, 8 and 1 was analysed. The moderate N input system consistently performed better regardless of season type, with small differences in the first couple years and the potential impact of the differences after five years more substantial (Figure 2), with $409 K better cash flow in the moderate intensity scenario.

© 2015 “Building Productive, Diverse and Sustainable Landscapes “ Proceedings of the 17th ASA Conference, 20 – 24 September 2015, Hobart, Australia. Web site www.agronomy2015.com.au Measuring farm performance over a range of season types is beneficial, as it shows the resilience of the farm over time and the ability to recover from a financial shock. This is valuable for developing the ‘big picture’ in scenario analysis and shows how discounted cash flow, equity and net worth are expected to perform over time. In the case study, a run of historical years starting in 2002 and finishing in 2006 corresponding to decile 2, 7, 4, 8 and 1 was analysed. The moderate N input system consistently performed better regardless of season type, with small differences in the first couple years and the potential impact of the differences after five years more substantial (Figure 2), with $409 K better cash flow in the moderate intensity scenario.

FigureFigure 2 Graphical representation of the 5 year outputs discounted cash flow onon thethe leftleft andand equityequity onon thethe rightright.. TThehe blackblack lineline showsshows thethe highhigh intensityintensity scenarioscenario andand thethe greygrey line shows the moderate intensity scenarioscenario..

ConclusionsConclusions This paper demonstrated some features of the profit risk calculator by using a Cummins case-study farm.The Thistool waspaper employed demonstrate to compared some featuresN management of the profit scenarios risk calculatorimpact on by financial using a Cumminsand economic case -studymeasures farm in . allThe tool was employed to compare N management scenarios impact on financial and economic measures in all rainfall deciles, allowing both downside and upside seasonal risk to be explored. We have established that the rainfall deciles, allowing both downside and upside seasonal risk to be explored. We have established that decile calculator is locally relevant, simple to use and practical tool that can help users to better understand the decile calculator is locally relevant, simple to use and practical tool that can help users to better understandhow seasonal how risk seasonal impacts risk on impactstheir farm on business their farm and business their farming and their decisions. farming The decisions. tool has The the tool flexibility has the flexibilityto explore toa rangeexplore of afarming range of scenarios farming withscenarios consideration with consideration given to maximising given to maximis profit ingand profit minimising and risk minimisaccordinging to risk user according preference. to user preference.

Acknowledgments Thanks to all the farmers and consultants that have attended workshops which helped to shape this work. Thanks toto allDr theAndew farmers Zull and (DAF), consultant staff ats thatNAB have Agribusiness, attended workshops and various which others helped for their to shape advice. this This work. study Thankswas financially to Dr Andew supported Zull (DAF),by the staffGrains at NABResearch Agribusiness, and Development and various Corporation others for (project their advice.CSA00036 This andstudy wasCWF00016) financially with supported co-investment by the Grainsfrom the Research CSIRO. and Development Corporation (project CSA00036 and CWF00016) with co-investment from the CSIRO. References HarwoodReferences J, Heifner R, Coble K, Perry J, Somwaru M (2000) Managing Risk in Farming: Concepts, HarwoodResearch J, Heifner and Analysis. R, Coble Market K, Perry and J,Trade Somwaru Economics M (2000) Division Managing and Resource Risk in Farming: Economics Concepts, Division, EconomicResearch Research and Analysis. Services, Market U.S Department and Trade ofEconomics Agriculture. Division Agriculture and Resource Economics Economics Report No.774Division, HardakerEconomic J (2003) ResearchSome Issues Services, Dealing U.S with Department Risk in Agriculture. of Agriculture. Working Agriculture Paper Series Economics in Report AgriculturalNo.774 and Resource Economics, University of New England, Armidale, NSW, HardakerNguyen N, J (2003)Wegener Some M, RussellIssues Dealing I, Camerson with RiskD, Coventry in Agriculture. D, Cooper Working I (2007) Paper Risk Series Management in Strategies by AustralianAgricultural Farmers: and Two Resource Case Studies. Economics, Australian University Farm of Business New England, Management Armidale, Journal NSW, Volume 4 numbers Nguyen1 and N, 2. Wegener M, Russell I, Camerson D, Coventry D, Cooper I (2007) Risk Management Strategies by Australian Farmers: Two Case Studies. Australian Farm Business Management Journal Volume 4 Monjardino M, McBeath T, Brennan L, Llewellyn R (2013) Are farmers in low-rainfall cropping regions numbers 1 and 2. under-fertilising with nitrogen? A risk analysis. Agricultural Systems 116, 37-51. Monjardino M, McBeath T, Brennan L, Llewellyn R (2013) Are farmers in low-rainfall cropping regions Monjardinounder M,-fertilising McBeath with T, Ouzman nitrogen? J, LlewellynA risk analysis. R, Jones Agricultural B (2015) SystemsFarmer risk 116, aversion 37-51. limits closure of Monjardinoyield and profit M, McBeath gaps in the T, Ouzmanmanagement J, Llewellyn of nitrogen R, Jonesin the Bsouthern (2015) AustralianFarmer risk wheatbelt. aversion Agriculturallimits closure of Systemsyield (in and press). profit gaps in the management of nitrogen in the southern Australian wheatbelt. Krause (2013)Agricultural Farm SystemsFinancial (in Tool: press). Cash Flow Budget Fact Sheet Krause https://www.grdc.com.au/Media-Centre/Ground-Cover-Supplements/GCS107/GRDCs-Farm-Business- (2013) Farm Financial Tool: Cash Flow Budget Fact Sheet Management-fact-sheets https://www.grdc.com.au/Media May 2015 -Centre/Ground-Cover-Supplements/GCS107/GRDCs-Farm- Business-Management-fact-sheets May 2015