3 FARM BUSINESS

MANAGEMENT
Economic thinking, which forms the basis of good farm
business management, can be a challenging area. This
section summarises the important parts of economic
thinking and how it relates to management.

3.1 ECONOMIC THINKING

3.1.1 Scarcity and opportunity cost
3.1.2 Production economics

3.2 MEASURING BUSINESS PERFORMANCE

3.2.1 Key management concepts

3.3 KEY BUSINESS ‘TOOLS’ AND INDICATORS

34 3.3.1 Profit and loss budget
3.3.2 Cash flow
3.3.3 Balance sheet
3.3.4 Enterprise gross margins
3.3.5 Other commonly used performance indicators
Module 1 - 3 Farm business management

3.4 WHOLE FARM ANALYSIS

3.4.1 Business planning cycle
3.4.2 Bringing it all together: cash, profit and wealth
3.4.3 Bringing strategic thinking to management

Farming the Business

35

Module 1 - 3 Farm business management

 3 FARM BUSINESS MANAGEMENT
Having a clearer understanding of your farm business financial performance is
a critical step toward improving business profits.

KEY POINTS

• Economic thinking is fundamental to sound farm • Maximum production does not mean maximum profit.
business management. • The key to effective farm business management is to
• Measures of liquidity, efficiency and wealth give the prepare, not predict.
complete business picture.

Co-contributor to this section: Tony Hudson, Hudson Facilitation.

The more traditional part of farm business management is

about applying economic thinking to make decisions about
‘...trying to grow the most profitable
managing the farm business. A business always has limited
resources. For a farm business, this includes land, labour,
crops, trying to reduce our costs.
management skill, finance, machinery and livestock. We all know what the answers are to
growing the highest yielding crops out
It is human nature to want more of something that is valued,
there, but it’s no good if it’s going to
which could be part of the business’ vision, but managers
have to manage within the resources they currently have
cost us more to grow than we’re going
or can control. Economic thinking is about how the limited to make out of it. No matter if it’s the
resources of the business are utilised to maximise goals, sheep or the cropping side of things,
including building wealth. Managing the resources we it’s the $/hectare. It’s profit at the end
control to make profit is a means to this end. This may sound of the day. It’s just a bottom line figure
simple, but there is a high degree of risk and uncertainty with for us. If we can focus on the bottom
seasonal variability and market volatility, which makes farm line all the time, I think that’s the best
management decision making and operations difficult. way to run the business.’
36
3.1 ECONOMIC THINKING Scott Nicholson,
‘Bretton Estate’, Campbell’s Bridge, Victoria
3.1.1 Scarcity and opportunity cost
Every business has to confront scarcity (i.e. limited resources).
to assess the economic outcome of alternate strategies is
We each have a limited capacity to fulfil a potentially unlimited
‘scenario analysis’. The key to this economic concept is to
Module 1 - 3 Farm business management

list of wants and needs. From a consumer perspective,

make decisions that continually help the business achieve
fulfilling our needs and wants provides a level of utility
goals that fulfil its vision.
(satisfaction) to the consumer. For most people, income
limits our capacity to fulfil our needs and wants, and we have Analytical tools are discussed further in section 11,
to make choices about how we spend our (relatively scarce) Module 3.
income to maximise the satisfaction we gain from it.
In a production context, for example, a decision to do one 3.1.2 Production economics
thing, such as purchasing the latest header, may limit the
Production economics is about the decisions farmers face
capacity to do another thing, such as purchasing additional
while aiming to achieve their goals from limited available
land. This decision therefore has an opportunity cost - i.e.
resources. Production functions (also called response
something else is given up in order to make this choice
functions) are the relationships between resources used
possible, which in this instance is purchasing more land. In
(land, labour, capital, water) and the resulting output. For
farm economics, all costs are opportunity costs.
example, if we have a fixed amount of one resource, such as
Opportunity cost is an economic concept that can be applied land, more output can only be generated by adding additional
to all business decisions on the farm. Essentially, when you variable resources to it, such as fertiliser, fuel, chemicals,
have limited financial resources, with each decision making labour, irrigation water and so on.
process, management should be asking, ‘Is this the best use
In agriculture, production functions are not usually linear
of the scarce finances available to the business?’ A method
relationships beyond the initial stage of inputs used i.e. the

Farming the Business

 law of diminishing marginal returns applies (see below). For This relationship of diminishing marginal returns to extra
example, a predetermined amount of fertiliser will not always variable inputs was clearly illustrated in a series of fertiliser
grow a known amount of grain; nor will doubling or tripling trials conducted at the Hart field trial site near Clare, SA, in 37
the amount of fertiliser necessarily double or triple the yield, the poor rainfall seasons of 2005 - 2007. The trial compared
even if all other conditions are identical. If no fertiliser were both a number of 2-year rotations and the level of fertiliser
applied at all, there is usually sufficient residual soil nutrition input (see Figures 3.2 and 3.3), and results reinforced the
to generate some level of yield as long as reasonable rainfall principle that input to maximize yield does not provide the
occurs during the growing season. maximum profit. Three fertiliser levels were assessed:

Module 1 - 3 Farm business management

Knowing the potential production function of inputs to • Low
output that may apply to your crops will help to identify
• Strategic (the adviser’s recommendation, depending upon
the ‘best-bet’ input levels that could give the best profit.
the season)
A. The law of diminishing returns • High

The Law of Diminishing Marginal Returns describes the

relationship between varying levels of an input (e.g. fertiliser)
and the resulting output (e.g. grain yield). As outlined above,
output from a certain input is not linear beyond some level of Figure 3.2: Trial gross margin results for the wheat/wheat
input. Typically, beyond a certain point, further units of input rotation 2005 & 2006
can actually decrease output. Figure 3.1 illustrates this effect
Trial 1: Wheat/wheat gross margins
when increased levels of nitrogen are applied to wheat: the
first 125kg/ha of fertiliser gives a clear and strongly positive
increase in yield, from about 0.5t/ha to around 3.5t/ha 600
(i.e. increasing marginal returns). However, as more 500
units of nitrogen are added, the additional grain produced 400
from each additional unit of nitrogen applied becomes less
300
(i.e. diminishing marginal returns). Eventually, a point is reached
$ / ha

where additional fertiliser input has a toxic effect and leads to a 200
decrease in total yield (i.e. negative marginal returns). 100
0

Figure 3.1: Yield response to fertiliser input -100

(Production function) -200
-300
4.5 Low Strategic High
4 Input levels
3.5
3 Negative returns 2005
Yield t / ha

2.5 2006
Diminishing returns
2
Total Source: P2PAgri P/L

1.5
1 Increasing returns
Figure 3.3: Trial gross margin results for the wheat/wheat
0.5 rotation 2006 & 2007
0
0 50 100 150 200 250 300 350
Trial 2: Wheat/wheat gross margins

kg of Nitrogen applied
300

Yield t / ha 250
Source: Hudson Facilitation 200
150
$ / ha

What are the financial implications of this yield response? 100

If a farmer’s aim was purely to maximise yield, then in the
50
example above, the farmer would apply 200kg of fertiliser to
the wheat crop. However, most profit-driven farmers would 0
advise against this level of input: it increases the risk of a -50
negative gross margin if maximum yield is not achieved. It -100
also ties up significant additional working capital in the wheat Low Strategic High
crop, some of which would be better spent on other variable
Input levels
inputs to other crops. This relationship between nitrogen and
yield will vary between rainfall zones and seasons, so check 2006
with your agronomist what this relationship is likely to be for
2007
crops in your area.
Total Source: P2PAgri P/L
 The trial design had one 2-year phase conducted in 2005 and nitrogen. However, the maximum profit of $535/ha is achieved
2006, with the second 2-year phase in 2006 and 2007. The by applying only 150kg/ha of nitrogen to produce a yield of
gross margin results of the wheat/wheat rotation are shown in 3.6t/ha of wheat. At this level of nitrogen use, the last 25 kg
Figures 3.2 and 3.3. In both phases of this trial, the best profits of N costs $15 and added close to an extra $15 to profit. All
were not obtained by applying the maximum fertiliser level. units of N up to this level added to total profit.
The main economic outcome from this trial was that in a poor The application of 125kg/ha of nitrogen produces 3.5t/ha of
season, it did not pay to apply high rates of fertiliser as it wheat. The additional 25kg/ha of nitrogen to reach maximum
caused two problems for economic efficiency: achievable profit at 150kg/ha costs an extra $15/ha. This
adds $20 extra revenue. Considering that this produces only
i. It caused higher costs, and
a further $20/ha in revenue, it may not be worth the added
ii. Produced poorer yields, resulting in less gross income. risk to achieve the resulting $5/ha in additional profit.
In every rotation tested, the high input treatment produced In production economics, the theoretical maximum profit
the poorest gross margin. How then, do you decide on the is achieved when:
appropriate level of inputs?
Marginal cost = Marginal return
B. Marginal cost and marginal return In Figure 3.1, this occurred at a nitrogen application rate
of somewhere between 150-175kg/ha. Beyond this point,
The marginal cost is the additional cost of applying one
the cost of the additional unit of nitrogen is greater than
additional unit of input to an activity, with all other inputs
the resulting income it generates. In theory, this is the level
held constant. To use the previous example, if the fertiliser in
at which nitrogen should be applied in the above scenario
question was nitrogen priced at $600/t, and one ‘unit’ was
if certainty prevailed. The reality however, of applying an
25kg/ha, the cost per unit of nitrogen is $15.00/ha. So the
additional $15 of nitrogen to gain an additional $20 of wheat,
marginal cost of an additional 25kg ‘unit’ of nitrogen is $15.00.
is for most farmers too risky to consider.
Similarly, the marginal return is the additional income
Uncertain factors in agriculture include weather, yield,
generated as a result of adding that extra unit of input. So
disease and prices of both inputs and outputs. With effective
if you are paid a farm gate price of $200/t for wheat, each
marketing strategies, many farmers can know with some
additional kg of grain earns us an extra 20 cents.
certainty the price they are likely to receive at harvest for
Table 3.1 illustrates this relationship. Each 25kg ‘unit’ of some or all of their produce. Similarly, the costs of inputs
nitrogen costs $15.00 and the first ‘unit’ of nitrogen results in such as nitrogen will be known precisely when such
an additional yield of 0.7t of wheat. At $200/t, this produces application is being considered, as will stored soil moisture
a marginal return of $140. Clearly the first unit of nitrogen is and medium range weather forecasts. The actual yield is
highly profitable - you will earn $140 in gross income at an unknown, therefore decisions about levels of input use have
added cost of only $15! to be tempered by knowledge of current soil moisture and
how the season is shaping up.
The calculation that maximum yield does not necessarily result
in maximum profit becomes more useful in decision making
when you consider risk. In the above example, the maximum
yield of 3.7t/ha of wheat is achieved by applying 200kg/ha of
38
Table 3.1: Sample marginal cost and marginal return

Nitrogen Marginal Yield Additional Marginal Marginal Profit

kg / ha cost t / ha yield return profit $ / ha
$ / ha t / unit $ / unit $ / unit
Module 1 - 3 Farm business management

0 0 1.00 0.60 120.00 105.00 105.00

25 15 1.70 0.70 140.00 125.00 230.00
50 15 2.30 0.60 120.00 105.00 335.00
75 15 2.80 0.50 100.00 85.00 420.00
100 15 3.20 0.40 80.00 65.00 485.00
125 15 3.50 0.30 60.00 45.00 530.00
150 15 3.60 0.10 20.00 5.00 535.00
175 15 3.65 0.05 10.00 -5.00 530.00
200 15 3.70 0.05 10.00 -5.00 525.00
225 15 3.65 -0.05 -10.00 -25.00 500.00
250 15 3.60 -0.05 -10.00 -25.00 475.00
275 15 3.40 -0.20 -40.00 -55.00 420.00
300 15 3.10 -0.30 -60.00 -75.00 345.00

Source: Hudson Facilitation

Farming the Business

 these types of decisions based on instinct or past practices, but it is often helpful
to test intuition
C. these typeswith
Equi-marginal science and
ofreturns
decisions basedeconomic
on instinctinformation.
• or past
If you werepractices,
to crop 1,000but
ha ofit is often
wheat helpful
and apply an extra
3 units of nitrogen (as per the example in Table 3.1), you
So to
far test intuition
we have with the
only provided science
simple and economic
application of information.
would require an additional $45,000 in working capital 39
nitrogen on wheat example to illustrate the theory of marginal throughout the year. Do you have access to this much
D. costs and marginal returns when making farm management
BUDGETING IS CRITICAL
decisions. Farming is more complicated than this, and on
extra cash?

mostD.farms, there
BUDGETING IS CRITICAL
is a range of potential crops which would • Could the higher working capital requirements limit your
Appreciating
benefit from thethe concepts
addition of production
of extra nitrogen. functions
How do we decide and
ability to domarginal
other things?returns supports
Appreciating
decision
where making but,
and when to theasconcepts
apply it? with anyofpartial
Remember, we production
are aiming to functions
analysis, care
• Are and
labourisand
neededmarginal
equipment returns
toadequate
make dealsupports
tosure all the extra
with

Module 1 - 3 Farm business management

maximise profit, not yield.
factorsdecision
that change making arebut, as with any
considered. partial analysis,
output?
A decision to increase care production
is needed tofrom make sure all
what
A production function such as that presented in Figure 3.1 • How might marketing strategies be affected?
mayexistsfactors
historically
for every that change
have
crop mayare
whichbeen considered.
bea grown,
‘normal’ not just level A decision
wheat. of inputstotoincrease one which production
is higherfrom in anwhat
Significant farm management decisions have implications
attempt may
In an
tohistorically
increase
environment have
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of scarcity been
should
(limited a ‘normal’
create
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additional
it is useful
manyinputs
harvest
parts oftotheincome.
onewhole which isand
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However,
system itinthorough
require an
to estimate the production function of each enterprise which
will may attempt
also require
benefit fromto increase
significant
additional unitsprofit, should
ofadditional
nitrogen. create
working
Estimating the additional harvest income.
capital to implement,
budgeting to ascertain full working However, itand
and raises
capital requirements
the likely profits from a range of seasonal outcomes, both
will also
the marginal
following costs require
and returnssignificant
questions: additional
from the production functionsworking
good and capital
poor. to implement, and raises
of alternate enterprises will assist with decisions around
the to
whether following
apply the next questions:
unit of input, such as nitrogen to
 If you
wheat, canola or peas. were to crop 1,000 ha of wheat and apply
E. Managing an extra
inputs 3 units of
with uncertainty
Once the marginal
If you
 return
nitrogen (as were
perofthe
per input
to crop
example
nitrogen
1,000used
for each crop
ha ofRisk,
wheat andand
is above), you would require an
uncertainty apply
surprise anareextra
central3features
units ofofrunning
established,additional
the next nitrogen
unit of$45,000 (as should
nitrogen per the
then example
in working capital
be applied used
a farm. above),
It is
throughout
experiencing
not you
possible
thewould
until harvest
to know
isyear.
whatrequire
finished.Do
type an you are
of season
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example, there are
to the crop which will achieve the highest marginal return for
have
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additional
access
While thisto
$45,000
this
looks much
obvious,
inextra
have
working cash?
you ever
capitalwhen
seasons throughout
a crop has grown the well,
year. Do
only you
to experience a

 Couldhave accessMany to this much extra cash?

frost at grain filling stage which then results in significant yield
calculated the numbers
the yourself?
higher workingfarmers
to make these types of decisions based on instinct or past
capital
continue
requirements limit your
loss. This can be financially abilityespecially
devastating, to do if a high
practices, but

other Could
things?
it is often
the higher working
helpful to test intuition with science
capitalinput requirements
cost strategy has limit
been your
adopted. ability to do
and economic information.
 Are labour other and things? equipment adequate to deal with the extra output?
Advisers are often asked which management strategy
is best: to be optimistic and plan for a Decile 7 season
D. Budgeting 
 How ismight Are labour and equipment
criticalmarketing strategies be(good adequate
affected? to deal with the extra output?
season) so that the opportunity can be maximised;
 How might marketing strategies
Appreciating the concepts of production functions and
or be beconservative
affected? and manage for a Decile 3 season (poor
Significant farm management decisions
marginal returns supports decision making but, as with have implications
season) and minimise for many
losses. parts
Either ofofthese
the strategies,
anySignificant farm ismanagement decisions
all factors have implications for many capital
parts of the
or mix of strategies, can be appropriate depending on the
whole system
partial and
analysis, require
care needed thorough
to make sure budgeting to ascertain
sequence of seasons full working
experienced, the financial situation of
thatwhole system
could potentially andlikely
change require
are thorough
considered. A decisionbudgeting
to to ascertain fullof as
working capital
requirements
increase production andfrom the what may profits
historically from
have been a range
a of outcomes,
the business such
and the attitude the good and
decision-maker to risk.
requirements and the likely profits from a range of outcomes, such as good and
poor‘normal’
seasons.level of inputs to one which is higher in an attempt Recent research shows that farmers’ decisions are often
poor seasons.
to increase profit, should create additional harvest income. influenced by the experience of the most recent season(s): if
However, it will also require significant additional working it was good, the inclination is to feel more confident and think
capital to implement, and raises the following questions:

What level
Whatof inputs
level
What level
will
of of provide
inputs
inputs will
the most
provide
will provide thethe
profitable
mostmost
outcome
profitable
profitable
rather the
outcomeoutcome
than
rather thanrather
the
bestthan
best yield?
yield?the best yield?
Source: P2PAgri Pty Ltd
ource:Source:
P2PAgriP2PAgri
Pty LtdPty Ltd
 that the next season will also be good. Likewise after drought,
farmers’ management for the following season can often appear
3.2 MEASURING BUSINESS
to be based on the assumption that it also will be poor. While PERFORMANCE
some seasonal patterns can occur, such as a series of wet and
dry years, there is little evidence that the seasonal outcome just
past is closely related to the next years’ conditions. 3.2.1 Key management concepts
When managing any business, have the following concepts
in mind:
Risk Management Simulation Workshop
i. Liquidity (Cash) – Cash flow management is to ensure
A risk management simulation workshop called more cash comes into the business than goes out, in
‘Future Farming Business’, developed by the the short-term and the medium term: Do you have
University of Western Australia, provides some enough cash to meet the day-to-day running of the
insight into the complex issue of managing inputs business when annual costs vary from year to year?
with uncertainty. This simulation workshop has been
modelled on the farming conditions and expectations ii. Efficiency (Profit) – This addresses the issue of
in the Great Southern area in WA, a cropping region whether the farm business is getting a return on the
with a relatively high growing seasonal rainfall. capital being managed that makes the investment of
This game is played over a number of seasons, using capital and time worthwhile. Profit and return on capital
a computer program. Each player starts with the managed is measured using a profit and loss budget
same farm and resources, and makes annual planning and a balance sheet: Is the business making enough
decisions with uncertainty, not unlike real farming. profit, after all expenses, to be sustainable?
Decisions of enterprise mix, grain marketing and iii. Wealth (Net worth) - This measures how business
input levels are taken before the full understanding of wealth grows over the year by comparing net worth
the season is known. at the beginning of the year to net worth at the end
The winners of the game are those that generate the of the year. If it has grown, then the year’s activities
highest net worth, which means the best sustained have been successful: generating enough cash to
profits over the seasons played. pay all the bills, making enough profit to justify the
investment, and building wealth which contributes
The most common strategies used by the winners toward achieving business goals. The wealth created
are to adopt a conservative management style, which through the year is generally a more important goal
may imply placing emphasis on minimising exposure and measure of success than cash and profit.
to losses is a sound starting strategy, depending on
how the season begins. However, in practice, making Is your farm generating enough wealth to help you achieve
the most of the occasional very good set of conditions, your goals?
both prices and yields, is also critical to success By measuring and managing with these concepts and goals
over the medium term. Initially planning for a Decile 5 in mind (see Figure 3.4), the farm owner will have criteria
(average) season but having the capacity – financially by which to judge situations and make decisions, both of a
and managerially – to be responsive to the season as tactical (day to day) and strategic (medium term) nature.
40 it develops would be a sound strategy. If the season
shows convincing signs of being above average, then
increasing the inputs can be an option, and vice versa. 3.3 KEY BUSINESS ‘TOOLS’
The challenge to management is to have the capacity
to respond to opportunities as the season unfolds. AND INDICATORS
For further information, contact Dr Amir Abadi: What farm business ‘tools’ do you need?
aabadi@iinet.net.au
Module 1 - 3 Farm business management

For a farming business to have a long-term future, it needs to

be efficient and have an ability to grow. A business that does
not grow over a period of 10 years will be going backwards,
not standing still, and this can only be tracked properly by
Action points measuring the key indicators of the business health of a
farm. But what are the tools that provide these indicators?
• Develop a comprehensive set of management Knowing the right financial tools to use to assess your
data, both physical and financial. business decisions will depend on your long-term business
• Be guided by realistic medium term trends in goals. Most farmers have one of two business goals – these
yields and prices when planning each year. goals, and the financial ‘tools’ to achieve them, are outlined
in Table 3.2.
• Practise using economic thinking in your decision
making.
These tools, profit and loss, cash flow, balance sheets and
• Develop these skills yourself to validate/check gross margin budgets, can be used for both looking ahead
professional advice. and looking back. They are the fundamental business
planning and recording tools for the farming business. They
are valuable for planning and then useful when completed
as ‘actuals’ at the end of the season, so that the business
performance is monitored.

Farming the Business

Figure 3.4: Key management concepts 41

Liquidity + Efficiency + Wealth = Sound business practice

Module 1 - 3 Farm business management

Enterprise
Cash flow Profit & loss Balance
gross margin
budget budget sheet
budget

Source: P2PAgri P/L

Table 3.2: Financial ‘tools’ to guide your farm business management

Financial ‘tools’ needed to

Farm Business Goal What do these ‘tools’ indicate?
plan and track business health

1. Continue to build the Profit - the measure of profit gives the financial
• Profit and loss budget
farming business and wealth performance of the business.
for the business to be viable
for the next generation.
Cash availability - measures whether the business
can meet its obligations of loan repayments and
• Cash flow budget
interest and the required living standards of the
owners.

Net worth – growth indicates the business financial

ability to manage risk.
• Balance sheet
Return on capital - measures business efficiency.
Equity – measures the percentage of assets owned.

Enterprise profitability - compares the relative

• Gross margins budget
contribution of farm enterprises to profitability.

2. Maintain and Measures whether the business can meet its

increase farm value as • Cash flow budget obligations of loan repayments and interest, and the
superannuation for the required living standards of the owners.
current generation operating
the farm. • Balance sheet Measures the owner’s wealth if the business is sold.

Source: P2PAgri P/L

 If a business has a clear set of goals, then these budgeting Operating profit tells how well all the assets the manager
tools can be used to assess how well the goals are being controls are being used, i.e. economic efficiency. The
met. These tools provide key measures of business health, indicator is return on capital managed - if this is low compared
sustainability and wealth generation. Without knowledge of with what other similar farms achieve and compared with
these tools, the owner or manager of the business is ‘running what other investments achieve, then a close look at the
blind’ and it is more difficult to manage business risk and business is warranted (remembering returns to capital also
capitalise on opportunities. Without information from this come from owning the land as well as from farming it).
set of budgets, business failure can come as a complete
Expected profit improvement is the test to use when assessing
surprise, to the owner, if not the neighbours!
any change proposed for the business. Figure 3.5 illustrates
the measurement of ‘net profit’ and business growth.
3.3.1 Profit and loss budget
Farm operating profit (also called Earnings Before Interest 3.3.2 Cash flow
and Tax: EBIT) is a key business indicator and will vary The banker’s truism that ‘a positive cash flow is king’ is well
significantly from season to season, as productivity is affected recognized by farmers: get the annual cash flow from the
by seasonal growing conditions and commodity prices by farming activities right and the profit and wealth creation follow.
market volatility. The operating profit achieved will depend on
the size of the business and the cost structure.

Figure 3.5: Profit and loss

Variable
costs

Farm
gross
income
Fixed
costs
Total
gross Finance
margin
Farm Tax
EBIT Farm net
profit (FNP) Farm net
before tax profit after Growth
42 tax

Figure 3.6: Cash flow Figure 3.7: Balance sheet

Module 1 - 3 Farm business management

Total liability
Cash
costs
Total assets
Total - land
cash
- machinery
inflow
- livestock
Principal
Cash flow & interest Net worth
before
principal Net cash
flow after
& interest
principal &
interest

Source: ‘Agriculture in Australia’, Bill Malcolm, et al, 2009

Farming the Business

Figure 3.8: Distribution of broad acre farm businesses by value of sales (total cash receipts) 2012-13
43
16

14

12

Module 1 - 3 Farm business management

10

0
Less than $60,000

$60,000 - $80,000

$80,000 - $100,000

$100,000 - $120,000

$120,000 - $140,000

$140,000 - $160,000

$160,000 - $190,000

$190,000 - $230,000

$230,000 - $270,000

$270,000 - $320,000

$320,000 - $390,000

$390,000 - $480,000

$480,000 - $590,000

$590,000 - $700,000

$700,000 - $800,000

$800,000 - $900,000

$900,000 - $1.1 million

$1.1 - $1.3 million

$1.3 - $1.7 million

$1.7 - $2.1 million

$2.1 - $2.5 million

$2.5 - $3.4 million

Greater than $3.4 million

Note: AAGIS excludes farms with an estimated value of agricultural operations of less than $40,000.

Share of population
Share of value of sales
Source: Australian Agricultural and Grazing Statistics Survey (AAGIS)

Most business failures occur because of an extended period over the years as a result of the farming activities.
of poor cash flow, resulting in the depletion of cash such Net worth also changes as a result of changes in the
as liquid assets and the ability to borrow additional capital. values of assets, especially farm land. This is the real
In general terms, the more that cash coming into the estate part of the business. It is good to measure
business exceeds the amount of cash going out, the net worth annually, on the same date each year, and
healthier the business. monitor its growth, from the farming activity and from
the change in land values. If it is not growing, then the
While this is a simple concept, the challenge is to continually
business will be in danger of becoming non-viable in
monitor cash in and out, best done monthly with a 12-month
the long-term.
budget of expected versus actual cash flows. A sound cash
flow is needed to build reserves for more challenging seasons. B. Equity: This measures the net worth as a
It also informs the owners and bankers of the business’s percentage of the business’ total assets and
ability to meet its lending obligations, which is another key indicates the financial security of the business.
performance indicator. Figure 3.6 shows the elements of a It indicates how much of the business is owned by
cash flow. the farmer. It is an indicator of financial strength and
capacity of the business to withstand times of low cash
flow and profits due to market downturns and poor
3.3.3 Balance sheet seasons. Dryland farmers usually run their business
Some farmers question the use of a balance sheet as they do with equity levels above 70%. Generally, equity above
not plan to sell the farm. A balance sheet provides the only 85% indicates farmers could consider expansion by
measure of business success if monitored over a period land purchase, but equity below 85% generally needs
of time. Also, when borrowing capital from a bank, a balance
sheet is essential for banks to assess the security you offer
them in exchange for the loan. ‘We try to have two, three or maybe
Figure 3.7 shows the components of a balance sheet. four years’ budget planning going on
and we’ve started benchmarking the
The key indicators from a balance sheet are: budget so we can look at the business
A. Net worth (also called equity): The best single health of those future budgets.’
indicator of how a business is performing over time.
Tony Geddes,
Net worth is the difference between total assets and ‘Yallock’, Holbrook, Victoria
total liabilities. In a sound business, this figure grows
 a period of consolidation to decrease debt levels. For example, issues that may be guided by benchmarking
include:
C. Return on capital: If you are interested in
measuring the efficiency of the business, then the • lambing percentage
best measure is return on capital managed (ROC). • weaning rates
It is calculated by dividing annual operating profit by • water use efficiency
the total assets managed by the farm. Greater than • machinery value / tonnes of grain produced
6%-8% return on capital from farming (not owning) • various bank ratios
indicates an efficient farm business; the top 25% of
However, while these highlight specific components of the
farms in any year achieve this, as well as a further 2%-
business, they do not provide the whole business picture.
4% from capital gain in land. Combined, this gives
returns to capital of 8-12% p.a., which is a very good A valid use of benchmarks is to measure key performance
comparison to other investments in the economy. On indicators of your own business against itself over time.
average, Australian dryland farmers earn around 2% This helps to assess if your business activities are improving
- 3% return on capital p.a. from farming. This reflects in the areas that are important to your goals.
that there is a small proportion of total dryland farmers
who produce a large proportion of total production, B. Tax returns
and a large proportion of farms that produce a small Tax returns are legally required to be completed annually to
proportion of total output, Figure 3.8. assess how much tax, if any, the farm business is required
to pay the Australian Taxation Office (ATO). As they are
3.3.4 Enterprise gross margins a legal document, banks appear to rely quite heavily on
the information provided in the tax return. Note that tax
Enterprise gross margins are used to compare the relative
information does not provide business performance
contribution of each enterprise to a farm’s profit, before
measures relevant to management decisions as they
overhead costs are considered. An enterprise gross
are completed to ATO rules. Some of the values used for
margin of a crop is the difference between the gross income
tax purposes are different to the figures that are relevant for
(yield x prices) less the cash costs of growing a crop (also
management decision making. While tax accounts have a
known as variable costs). As land is usually the most limiting
‘profit and loss’ and a ‘balance sheet’, these do not use the
resource on a farm, the gross margin is normally expressed
same numbers as farm business management and so do
as $/ha. So, if a wheat gross margin is $350/ha and barley is
not provide a true measure of business profit or a true record
$275/ha, then wheat is making a greater contribution to farm
of the worth of business assets. Despite the irrelevance of
profit than the barley crop. The key to using gross margins
tax accounts for management purposes, many Australian
is balancing the financial expectations with the agronomic
farmers use their tax return as their major measure of farm
requirements of the farming system. Some enterprises
business performance, and thereby gain very little useful
provide complementary benefits rather than just being
information about how well or poorly they are managing the
competitive for land; for example, grain legumes provide
assets they control.
nitrogen to the following season’s cereal crop.
A good accountant can help produce a set of farm business
3.3.5 Other commonly used management budgets in addition to the tax budgets. This will
provide an accurate measure of business performance and
44 performance indicators an accurate measure of equity. These would then provide
a sound set of financial records that give information to
A. Benchmarks
understand and improve the management of the business.
Benchmarking is a farm management analytical method initially
Key business ‘tools’ and financial indicators are discussed
developed to compare farming businesses. However, there
in greater depth in section 5.5, Other performance
are no two identical farming businesses, which makes
indicators, Module 2.
Module 1 - 3 Farm business management

meaningful direct comparisons difficult. When using

benchmarking data comparing businesses, at best they may
raise questions of various parts of the farm performance, in a
‘compare and contrast’ sense. It is difficult to identify solutions
for one farmer’s situation and goals using benchmarks from
another farmer’s situation and goals. Farm problem solving
and identification of opportunities can only be done on a whole
farm case-by-case basis, using scenario analysis.
While technical benchmarks such as yield/ha and water use
efficiency/tonne provide some useful technical information
about what happens on similar types of farms, benchmarks
are only reference points about parts of the operation of a
farm business, not indicators of whole business performance.
Most business benchmarks are ratios and should be used to
identify the issues a business needs to focus on; they cannot
be used to provide solutions. Benchmarking assesses only
parts of a business, whereas solutions require consideration
of the whole business.

Farming the Business

3.4 WHOLE FARM ANALYSIS
‘Budgeting is absolutely essential. We 45
3.4.1 Business planning cycle are very stringent on that. We have
It is valuable each year to have a major planning phase quarterly board meetings where we
that follows an accurate reporting of the previous season. present budgets and go through our
Your tax return and cash flow reporting are not adequate to profit and loss, and budget actuals on
give all the information your business needs to be managed the way through. We take our actual
sustainably. results from the previous 2 to 3 years

Module 1 - 3 Farm business management

Regularly monitoring business performance by evaluating and use those to sit down and plan
indicators of profit, cash flow, net worth, equity and return on for the future. In a business of our size
capital is the only way of knowing whether failure is only days and scale, it is really important to know
away, or whether there is capacity to expand and continually when money is coming in and when it
improve aspects of the business.
needs to go out.’
A feature of every well managed business is that they have a
planning cycle comprising periods of goal setting followed by John Gladigau,
action and monitoring, with results feeding back into the re- ‘Bulla Burra’, Allawoona, SA
setting of goals and targets. It can be an annual cycle (Figure
3.9), quarterly or monthly cycle, depending on the intensity
of the business.
Farm business management requires focus on both part
and whole business measurements in order to find business
solutions and test business decisions. Your business
feedback should come from a combination of the following
farm business performance ‘tools’: Profit and Loss, Cash
Flow, Balance Sheet and Enterprise Gross Margins.

Figure 3.9: Farm business yearly planning cycle

Beginning of farming season:

analyse and plan

• Set goals
• Project your:
After season finishes: evaluate Profit & loss
Cash flow
Balance sheet
• Performance indicators Gross margins
Profit
Cash on hand Each month: implement plan
Equity
Gross margins • Monitor cash flow
Net worth
Return on capital
Industry benchmarks

End of season

Source: P2PAgri P/L

 3.4.2 Bringing it all together: cash, Step 2: Calculate Annual Profitability
profit and wealth This is measured by a Profit and Loss budget.

Co-contributor to this section: Assoc. Prof. Bill Malcolm, Gross income – Variable and Fixed Expenses
University of Melbourne. = Operating Profit
Table 3.5 shows the annual Profit and Loss for this sample
farm. Gross Income from grain and livestock sales is $1m.
‘The key to farm business management The Variable Costs are those cash costs that can be directly
is to assess the whole business and attributed to grain and livestock production. In this example,
it is $600k, which means the Total Gross Margin is $400k.
not just parts of the business. We can
The overhead costs of $200k are taken away from the total
have a tendency to focus on each gross margin to get an Operating Profit of $200k. This figure
enterprise, one at a time. This may is also known as Earnings Before Interest and Tax (EBIT).
allow us to isolate problems and look
The growth in owner’s equity is $85k. This is a good result as
for solutions. However, we should not
it is positive, rather than negative. However, the true measure
lose sight of the whole business. This
of success would be if this was compatible with the growth
is called the ‘whole farm approach.’ goal of the owners of the farming business.

Assoc. Prof. Bill Malcolm, Other business efficiency measures that can be calculated
University of Melbourne from the Profit and Loss budget are shown in Table 3.6.

Step 3: Calculate Annual Cash Surplus

This section brings the annual farm business (Liquidity)
management budgeting cycles together and This is measured using an annual Cash Flow budget. It is
shows how the balance sheet, profit and loss and important to note that the cash story is different to the profit story:
cash flow interrelate to provide the broad picture of
• A Profit and Loss budget takes into account hidden costs
the farm business performance.
such as depreciation, and hidden income such as change
The farm family business has the following components: in inventory of unsold production, whereas a Cash Flow
budget only takes into account uses of cash and sources
• The people who own, manage and work in the business
of cash.
• The technology used to guide production
• The Cash Flow in Table 3.7 shows a Gross (Cash) Income
• The economic environment of $1m, which in this example is the same as the Gross
• The finance of the business Income for the Profit and Loss. However, the overhead
• The risk of business costs in the Cash Flow do not include the depreciation
cost as this is not a cash item. In this example, the
• Issues beyond the farm gate
machinery value of $1.0m is depreciated at 7.5% p.a.,
The challenge for farm management is that all these things giving annual depreciation of $75k. So the Cash Overhead
46 need to be managed together. We need to find solutions to Cost is $125k ($200k - $75K).
the whole problem. Solutions to parts are not solutions to • Annual Net Cash Flow includes any capital purchases
the whole. that have been bought with cash. In this example, the
It is important to see how cash, profit and wealth are linked farm bought $75k of equipment, which shows up on the
and how all three measures are needed to assess the balance sheet as an additional asset.
performance of the business. • Annual Net Cash Flow also includes any principal
Module 1 - 3 Farm business management

repayments. In this example of a $1m loan needing to be

The following example, based on a mixed farm of 2,000
repaid over 10 years, the annual principal repayment is
ha, demonstrates the relationship between cash, profit and
$100k.
wealth, and follows the Farm Business Yearly Planning Cycle
in Figure 3.9. By subtracting the principal payment of $100k, interest
payment of $100k and tax of $15k, the annual Net Cash
Step 1: Calculate Opening Wealth Flow of the business is negative $15k. This loss is not a good
outcome for the business as it needs to be funded from
At the beginning or opening of the year, the farm’s wealth
additional debt. (If this was a projected Cash Flow, provision
(both net worth and equity) can be assessed using a
would have to be made to finance this extra debt, or change
Balance Sheet (Table 3.3), which measures both opening
the plan to ensure a surplus.)
assets and liabilities.
In this example, there is only one debt to the bank of $1m. Step 4: Calculate Closing Wealth
This is a 10-year loan with an interest rate of 10%, so there is
Check what has happened to the end of year Net Worth and
an annual principal repayment of $100k.
Equity by putting the end of year Balance Sheet together, as
This provides a ‘bottom line’ of opening values against which shown in Table 3.8.
to measure the growth of business wealth across the year
• Land value remains at $4m, but machinery is now valued
(Table 3.4).
at $925k as it has been depreciated by 7.5%, or $75k.

Farming the Business

Table 3.3: Sample farm’s opening balance sheet Table 3.6: Efficiency measures
47

Assets Liabilities Operating profit = Return on capital

total assets managed managed (ROC) %
Land value $4.0m Bank debt $1.0m
$200k $5.5m = 3.6%
Machinery value $1.0m

Module 1 - 3 Farm business management

= Return on owners’
Livestock value $0.5m Net profit equity
equity (ROE) %
Total assets $5.5m Total liabilities $1.0m $100k $5.5m = 1.8%

Table 3.4: Opening values Table 3.7: Sample farm’s cash flow

Total assets – total liabilities = Opening net worth Gross (cash) income = $1m

$5.5m - $1.0m = $4.5m Variable costs - $600k

Net worth total assets = Opening equity % Cash overhead costs - $125k

$4.5m $5.5m = 82% Capital expenditure - $75k

Net cash flow before loan

= $200k
payment and tax
Table 3.5: Sample farm’s profit and loss
Principal payments - $100k
Gross income (grain and livestock) $1.0m Interest payments - $100k
Variable costs - $600k Tax - $15k
Total gross margin = $400k Net cash flow = - $15k
Overhead costs - $200k

Operating profit (EBIT) = $200k

Table 3.8: Closing balance sheet
Interest payments - $100k

Net profit = $100k Assets Liabilities

Tax - $15k Land $4m Bank loan $900k

Growth of owners’ equity = $85k New loan from the
Machinery $925k $15k
cash flow deficit
Livestock $0.5m
• The livestock value remains the same at $0.5m and $75k
of new capital investment has been purchased out of cash New Capital $75k
flow. The total assets have remained unchanged at $5.5m.
Assets like land and livestock are periodically revalued but Total assets $5.5m Total liabilities $915k
within-year changes are kept separate so as to not distort
the measure of performance from the farming activities. Source: P2PAgri P/L
• The original bank loan has been reduced to $900k by the
$100k principal reduction. However, new debt of $15k
has been incurred due to the negative annual cash flow of Table 3.9: Change to net worth and equity
$15k. Total liability has moved to $915k.
The changes in net worth and equity for the year are shown
Net worth Equity
in Table 3.9.
The growth in net worth of $85,000 from the beginning of Opening = $4.5m Closing = $4.585m
the year is the recorded net profit for the year (as no tax has
been paid). Opening = 82% Closing = 83.4%

Source: P2PAgri P/L

 In summary, the results for this sample farm are: B. Scenario analysis
• Cash: The annual net cash flow of -$15k is not desirable, Imagining the future is powerful when you are developing the
but equity is strong enough for the bank to advance this business vision. It is helpful to model the farming business
amount. given different events, such as poor prices and poor seasons,
• Profit: Profit (growth in equity) is $85k, which represents using ‘scenario analysis’. Management of the debt levels can
a return on capital managed of 3.6% - an average rather be assessed by these scenarios.
than good level of economic efficiency.
This is a really useful tool to assess the risk profile of the business
• Wealth: The Opening Net Worth was $4.5m, which and assess different strategies for the business to withstand
grew to $4.585m at the end of the year. This is a positive whatever risks it needs to face. The key is prepare, not predict.
movement in Net Worth, which is a good sign. We cannot predict the future, but we can prepare for events that
Note: No single one of these indicators tells enough about are likely to occur, such as drought and market downturns.
how the business is performing - all three measures are The key to success in farming is to be flexible and to adopt
needed. It may not always be that all three indicators show new technology to keep you profitable. In farming, if you are
the business is doing well. The profit can be sound but the standing still, you are going backwards!
cash position unsound, and vice versa. If all three indicators
are showing poor results, it is a sign that the business needs Analytical tools are covered in greater detail in section
to seriously assess the reasons why and look for strategies 11, Module 3.
to turn the situation around.
C. The relationship between debt and equity
One key to the success or failure of a business is the
3.4.3 Bringing strategic thinking to relationship of debt to equity. The principle of ‘increasing
management financial risk’ has a dynamic effect on business performance,
as illustrated by the following example:
A. Risk
Risk refers to the fluctuations of seasons, prices and other
variables that directly affect the profit, cash and wealth of the Example of Increasing Financial Risk
business. Australian farmers face more risk than any other
A farm with $10m in assets and $5m in debt has
farmers in the developed world.
equity of $5m. If this farm earns 10% ROC, that’s
Risks in Australian agriculture: a profit of $1m. The interest bill for that farm at
• Minimal government assistance compared with farmers 8% interest on $5m debt is $400k. This leaves a
in most developed countries. Net Profit of $600k. The change in equity for this
farm is $600k, which is a growth in equity of 12%
• Significant climate variability, particularly evident in the last
($600k/$5m). This is a good result.
10 – 15 years.
• Direct exposure to international commodity markets, +10% ROC 12% growth in equity
interest rate movements and exchange rates. Consider what happens when the opposite occurs
Risks to individual farm businesses: when there is an Operating Loss of 10%. This farm
48 loses $1m. In this situation, the interest bill is still
• Business risks – The uncertainty of prices, seasonal
$400k, but the Net Profit for the year is -$1.4m.
drought and disease outbreaks.
This gives the business a 28% drop in equity
• Institutional risks – These are issues beyond the farm’s (-$1.4m/$5m), which is a very poor result.
control and include government policies, market changes,
international events and exchange rates. -10% Loss -28% decline in equity
• Financial risks – You have some control as you decide
Module 1 - 3 Farm business management

whether to take on added debt.

This example highlights that when things go well, the business
Attitude to risk:
moves forward at a certain rate. However, when things go
Managing these types of risk is the key to success in badly, the decline is much more rapid.
Australian farming. With these significant risks, it is easy to
A snowball effect also occurs when things go bad as the
have a defensive view and avoid risk. However, it should be
asset value declines. This makes the equity decline even
recognised that it is risk that creates the return. Economists
further and increases the gearing ratio, further exposing
would say that business profits are a reward for the risk taken
the business. The business will now be seen to be a higher
by the business. Your risk preferences are important, but
risk, resulting in higher interest rates from the bank. All these
remember that if you want a low business risk life, then you
elements create a snow-balling effect where the equity in the
will have a low business return.
business is quickly eroded.
Risk management is covered in greater detail in section
The key point of the principle of ‘increasing financial risk’
7, Module 3.
is that too much debt will expose the business and it will
Having an offensive (positive, opportunistic) view of risk not survive. However, keep in mind that too little debt will
allows you to manage opportunities as they occur. mean you may not grow fast enough compared to your
competitors. This will again expose the business to higher
risk. The key is to have the right amount of debt.

Farming the Business

 For more information on HOW to measure your farm
business performance, go to section 5, How do i measure
the financial performance of my farm business? Module 2.
49

Characteristics of a good farm manager:

• The farmer who is passionate about their
business. They love what they do, and this helps

Module 1 - 3 Farm business management

with resilience and getting the business through
the hard times.
• The farmer who wants to be the best at what they
do. This striving for excellence gets them focused
on continual improvement.
• The farmer who knows his business well and
what makes the business money.
Put these three characteristics together, and you have
a successful farm manager!

Action points
Use these farm business management budgets to:
• Develop your farm business budgets at the
beginning of each season.
• Record your actual farm performance.
• Evaluate your business results at the end of
each season.
• Measure your business’ financial performance
each year.
 REFERENCES

Dillon, J (2008), The definition of Farm Management, Journal of Agriculture Economic Vol 31, Issue 2

Edge Management, http://edge-management.com/

Malcolm B. et al. (2009), Agriculture in Australia, Oxford University Press, 2nd Edition.

Malcolm, B, Makeham, J and Wright, V (2005), The Farming Game: Agricultural Management and
Marketing, Cambridge University Press, Melbourne.

50
Module 1 - References

Farming the Business

GRDC RESOURCES 51
Other information relating to the topics covered in
Module 1 can be found in the following GRDC Fact Sheets:

Are you a good labour manager? (ORM, 2013):

http://www.grdc.com.au/GRDC-FS-GoodLabourManager

Building emotional resilience (ORM, 2013):

Module 1 - GRDC resources

http://www.grdc.com.au/GRDC-FS-EmotionalResilience

Farm business overview:

http://www.grdc.com.au/GRDC-FS-FarmBusinessOverview

Farm business risk profiles (ORM, 2013):

http://www.grdc.com.au/GRDC-FS-FarmBusinessRiskProfiles

Making effective decisions (ORM, 2013):

http://www.grdc.com.au/GRDC-FS-MakingEffectiveBusinessDecisions

Managing People in the Farm Business – Being an Effective Leader (ORM, 2014):
http://www.grdc.com.au/GRDC-FS-ManagingPeople

Production economics:
http://www.grdc.com.au/FBM-ProductionEconomics

Simple and effective business planning:

http://www.grdc.com.au/FBM-SimpleEffectivePlanning

Taking care of your personal health (ORM, 2014):

http://www.grdc.com.au/GRDC-FS-PersonalHealth

Your farm business management checklist:

www.grdc.com.au/FBM-Checklist