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Virtually everyone will agree that we are in challenging times. There are the obvious challenges, external to the farm itself, relating to drought, grasshoppers, BSE and the list goes on. Government programs, trade related issues and dollar exchange rates are a few more.
Not all sectors experience challenges at the same time, but it is pretty much a given that sooner or later, things come around. No one sector can claim exclusivity when it comes to experiencing management challenges. For example, the potato industry experienced year after year of significant growth in the demand for French fries and the industry was in a pretty strong position. Then along comes increasing concern about weight problems and diet awareness, and demand softens. Is it an emerging trend or a shorter term deviation? An emerging trend scenario will definitely result in challenges for processors and producers and changes will be required.
Here is yet another example of challenges producers face: In June 2003, McDonald’s announced they were going to phase out growth-promoting products in their meats. Now, they consume about 2.5 billion pounds of beef, chicken and pork. That’s a lot of meat! There does not appear to be a lot of scientific evidence that links these growth-promoting products to be health risks. What supports the move is not about science but rather, about corporate positioning and consumer demand. So are there challenges here? Absolutely!
There are usually close correlations between challenges and change. There is a fairly well recognized saying that where there is change, there is opportunity.
This graphic was taken from the Winnipeg Sun nearly a year ago. The caption is self-explanatory in what it is. But the real message is in what it represents – change, fundamental change. To a large extent, this is about consumer confidence in our food system. And while the practice is being implemented in Europe, it will not be long before similar practices are commonplace in Canada and North America. Certainly, this represents change in agriculture. There is opportunity here for sure. The trick is to find the opportunity that exists within the change.
Those are examples of external challenges that farm business managers are facing. There is also a long list of internal challenges, such as managing a farm as a business in increasingly complex operations (complex in terms of size, diversity, and legal structure). As capital requirements and environmental awareness and sensitivity increases, there is greater risk in farming every year. One of the emerging internal challenges facing farm managers involves the management of the business’s human resources.
Given that management challenges exist, different management skills will be needed to ensure farm businesses thrive. More and more, farmers will need to recognize and adapt to change. There is an increasing emphasis on a business management focus. No longer can farmers rely solely on good production management skills to see them through challenging times. They must integrate production, marketing, human resource and financial management activities. This requires more attention to planning. Planning not only for the next production year, but more importantly, longer term planning that is strategic in nature. Farmers need to ask themselves some basic questions about what they want their businesses to look like in five years. In other words, what their vision for their business is. Once the vision is articulated, they must set a course of action, or business strategies, that are designed to work toward accomplishing the vision.
While all areas of management require attention, financial performance remains key and underpins the other management components.
Using Financial Performance in Setting Business Strategy
Businesses face real challenges in creating and sustaining profit. Notwithstanding the achievement of personal and family goals and the personal enjoyment of working in the business, management focus should be on increasing owner value. Owner value can be measured in several ways, the most common of which is in financial performance such as increased cash flow, increased equity, better utilization of capital and optimized profit, to name a few.
Who doesn’t want to report better financial results? What’s often missed is the connection between financial performance as presented in the year-end financial statements and setting business strategy. Very clear financial performance can be, and should be, used in developing, implementing and modifying business strategy.
There are several reasons for this. Often, there is no connection between business strategy and financial statements.
First, strategy is about where the business is going - the five-year
thing - while financial statements report on where the business has
been. That is, what happened last year or in the last couple of years.
Second, most businesses need to focus attention on the urgency of managing cash flow.
Third, profit margins are often small and there is a tendency, and
sometimes urgency, to try to better manage operations to achieve
improved profit. Depending on your operational cycle, this can be a
relatively short-term activity. What should be looked at is what can be
done strategically and longer term that would provide the results you
What needs to happen is that farm business owners actually discuss, develop and agree on longer-term strategy. That is, where do you want your business to be in five years and what do you have to do to get there.
The connection between financial performance and strategy development is two fold. Businesses should use financial performance indicators in developing strategy and once developed, they should use financial information to test what progress is being made toward achieving the strategy.
The following statement is an example of how a business can use financial performance in setting and monitoring strategy:
The owners of Smith Farms will accept a minimum annual return on equity of minus 4% on combined operations and believe that the business should be able to provide a target return of 16%. It is expected that owner equity increases by at least 6% per year, maintaining an average leverage of 1/1.
Let’s take a look at that statement. What it is saying is that owners accept that, once in a while, something will happen in the business or in the industry in general, that results in a loss for the year. It goes on to state that they believe the business should be able to achieve a good return, if everything goes as planned. However, things happen in business. Targets are often not achieved and they accept that as well. They do, however, expect that the business at least reports a certain return.
Businesses can make decisions that will increase the likelihood of achieving certain financial goals. Usually risk is associated with these decisions. Theoretically, the greater the risk, the greater the return. Often the decision involves borrowing money. Businesses can actually report better financial performance by using more borrowed money. This is called leverage. So the last sentence in the statement puts a parameter around risk associated with leverage. In this way, the business owner cannot simply borrow more money in an attempt to improve financial performance as expressed by return to equity because that would result in greater leverage and more risk.
The question then, is how does this translate into strategy? There should be a discussion and agreement among owners on the indicators as described in the statement above. This activity is simply one of the things that owners must do in setting strategy.
It is generally somewhat easier to set the desired return, 16% in the example. Equity in your business is the difference between the value of all assets (all things you own in the business, including cash, land and buildings and equipment) and all liabilities (money you owe). Return on equity is the relationship between the equity in your business and your profit. If your equity (difference between assets and liabilities) is $500,000 and your profit is $50,000, then you have a 10% return on equity. Everyone would love to get a great return on equity, but this indicator should be set realistically. Can the business actually ever achieve this target? If not, as the business proceeds owners can find themselves disheartened by never achieving the target and this can be counter-productive.
It is far more difficult to set the minimum target. As noted, most businesses accept they will lose money sometime due to circumstances. The question is, how much? And in a business with multiple owners, there is very likely some disagreement on what is acceptable here. Just how much money are you prepared to lose? If your answer is none, then what must be done/what strategy must be used to ensure that this does not happen?
There is a follow-on point to make here. And that is, if you are prepared to lose 4% in a year, how many times will you accept this until you decide to do something differently in the business so the chance of a loss is reduced? Again, what must be done/what strategy must be used? This is a particularly difficult exercise to work through as most business owners are optimists and would rather think of all the positive things that will happen in the business rather than the negative possibilities.
The most difficult aspect is the expected return because this is the financial performance that, year in, year out, will be achieved given the normal operational variability that exists in the business (in this case 6%). Further, this decision should be made in the context of the opportunity cost associated with getting a return on the equity you have invested in the business.
In other words, assume your equity in the business is $500,000. If someone were to give you $500,000 cash and you were going to invest it, what return (expressed as the interest rate in money markets) would you require before investing? Having $500,000 in cash or $500,000 in equity is really no different, at least from the perspective of what return you want. Theoretically, if the business cannot achieve a 6% return, what must be done/what strategy must be used? Often when faced with this decision, business owners try to improve operations and/or expand. This simply perpetuates and/or magnifies the problem. Sometimes there needs to be quite significant strategies used, such as diversification or value-added, so as to increase margins or even exiting the business.
Building owner value is vitally important and requires that businesses develop and implement strategies that are designed to achieve it. Financial performance can provide very useful information when determining which strategies to use and how they are measured. Clearly, financial performance should be much more than looking at the business ‘from the rear view mirror’!
By Terry Betker, Director, Agriculture - Industry & Government. For more information, please contact your local MNP advisor or Terry at 1.877.500.0795.
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