What is a more important metric to watch, “Cash Flow” or “Profitability”? If you were to ask a consultant or college professor, the answer would be a very clear, “It depends.” Both metrics are important to gauge the health of your business. We tend to focus on Profitability because all businesses want to be profitable at the end of the year. Cash Flow analysis and forecasting can help plan purchases for better pricing.
First, a couple of definitions. Cash Flow is the amount of cash you have at any given time. It is found by the amount of cash inflow minus cash outflow. Positive Cash Flow occurs when incoming cash is greater than expenses. Negative Cash Flow occurs when expenses outpace income. Incoming cash is both cash from sales of grain or meats plus any funding from loans taken out. Loans are credited in the month the money is received. Expenses are any cash outlays during the month. A monthly loan payment is considered outgoing cash and is accounted for each month of the payment.
Profitability is the amount of money left after all expenses are considered. Gross Profit is Total Revenue minus Cost of Goods Sold (COGS). COGS are all the expenses that go into the production of crops. So it is the cost of seed, fertilizer, herbicide, etc. that are incurred. Net Profit is Gross Profit minus any other expenses you incur. Renting land or equipment, labor costs, and loan payments are all examples of expenses to be considered to find Net Profit. Net Profit is the bottom line profit number we are usually most concerned with. By taking Net Profit and dividing it into Gross Profit we have our Profitability Margin. This margin ratio can be looked at from year to year to see if the business is growing healthier.
Cash Flow can be planned out in advance. The grid below shows a Cash Flow plan (all numbers are in thousands). Now we can see that February has more expected cash outlays than cash inflows. We want to make sure that we have enough liquidity to cover the months where there are negative cash flows. Negative Cash Flow is a problem that can be fixed, however. Richard Warr, Associate Dean for Faculty and Research at North Carolina State describes it as, “…a problem easily solved with a line of credit at the bank to cover those negative cash flows, or just a fatter bank balance.” At times you may want to develop marketing strategies with Global Commodity Analytics and Consulting to ensure you have enough consistent revenue to support your expenses. It is much less desirable to be in a situation where you have to sell product at the wrong time in order to afford COGS in the future.
Profits are calculated a little differently. The grid below is a very simplified version of calculating profits. Our annual revenue is the top line and Gross Profit is calculated by subtracting COGS from Revenue. Again COGS are inputs like seed, fertilizer, etc. Once we have the Gross Profit number we begin subtracting all the line items that are not in COGS. Labor, loan payments, and equipment costs are self-explanatory. SG&A stands for Selling, General, and Administrative Expenses. These are all the expenses that are used to drive revenue. It includes things like office expenses, marketing research expenses, etc. We can then divide Net Profit from Revenue and see this year we had profit margin of 15%.
Indeed, Cash Flow can be negative for a farm that is growing. If you are buying land, your cash outflow could be negative. That could be good if your strategy is to increase your revenue through land acquisition, for example. New equipment purchases can also lead to negative Cash Flow, but if your strategy is increased productivity you can plan for the negative Cash Flow periods. Warr states, “Profit does not capture money put back in the business (to buy more equipment, etc.), so for many growing businesses, they may be profitable, but have terrible Cash Flow positions because they are plowing money back into the operation.”
As you can see by looking at both grids, we can have a profitable farm and still have months with negative Cash Flow. Knowing this is possible allows us to plan. Ideally we want to avoid taking out short-term loans when we need to buy seed. Or in the meats, find ourselves in a situation where we have to sell animals early because we are in a cash crunch. Many businesses find themselves in situations when they have negative cash flows. Think of Tesla as they were building their factories and designing their electric cars. They had many months of negative cash flows. By planning for it, they were able to design strategies to overcome the issue. Farmers need to do the same. Plan for the months where Cash Flow is negative, even when the farm is profitable. It will increase your profits.
If you have any questions about Cash Flow planning, please reach out to us at Global Commodity Analytics and Consulting. My number is (510) 364-1484.
Hypothetical Disclosure—HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. General Risk Disclosure—There is substantial risk of loss in trading futures and options, therefore you should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances. The information above is not meant to be advice to buy or sell futures and options. Options Risk Disclosure—The purchaser of options should be aware that he could lose all premium paid for such options as well as any commissions and fees. Further, purchasing deep-out-of-the-money options have a remote chance of becoming profitable. The writer or seller of options should be aware that there is unlimited risk and could result in such seller being required to maintain a futures position with any associated liabilities for margin. Past performance is not necessarily indicative of future results. Information Disclaimer—The information and data contained herein was obtained from sources deemed reliable. Their accuracy and completeness is not guaranteed. Any decision to purchase or sell based upon such information is the responsibility of the person authorizing the transaction. Prices could already have factored-into them the seasonality or cycles of the market. Copyright, 2021 Global Commodity Analytics & Consulting LLC