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Financial sensitivity testing

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What happens if revenues decline by 5 percent?

It is the time of year to close down the books for the existing year and start planning for next year. One of the key tools in business planning is the development of a traditional cash flow. Depending on the business or enterprise, a monthly or quarterly cash flow can assist one when thinking through projected production and marketing expenditures for the next year. The business cash flow comprises up to 80 percent of a business plan. In the days of uncertainty with game changing events around every corner, financial sensitivity shocks can provide the parameters of business outcomes that need to be tracked and monitored. During a recent online school, agricultural lenders were polled to determine the sensitivity tests that they are using with their farm and ranch customers.

Many agricultural lenders are using the 5-5-3 financial sensitivity test that was suggested decades ago in my book Weighing the Variables. Simply put, what happens if revenues decline by 5 percent? What if costs increase by 5 percent? What if interest rates rise by 3 percent? Determine how the business would be affected by each shock test. In today's world, this financial sensitivity shock might need to be increased to 10-10-3 or a 10 percent decline in revenue and a 10 percent increase in costs. A 3 percent increase in interest rates will probably suffice in the current environment of low interest rates.

With the dependence on government supports for cash flow, other lenders are stress testing a reduction in the amounts of government payments by 25, 50, and even 75 percent to determine how the bottom line profitability and debt coverage ratio will be impacted.

Those agricultural lenders that are working with vertically integrated operations, such as poultry and hogs, are shock testing by decreasing the number of flocks or turns, reducing placements, or increasing the length of layout time to determine financial sensitivity.

In regions of the country that are dependent on off-farm income, gig” income, or outside businesses, the lenders polled are reducing or eliminating this net income to see how the bottom line and cash flow are impacted. Some lenders are assessing the integrator and processor interruptions and are using percentage reductions to determine potential outcomes.

Enterprise specifics and breakeven analysis per acre, per animal unit, or per greenhouse square footage are being used by some lenders in parts of the country where these types of operations are popular.

A few agricultural lenders are taking their analysis beyond the cash flow to the balance sheet to do sensitivity testing on working capital and burn rate on core equity.

In today's world, using a spreadsheet to conduct financial sensitivity analysis can be a great tool to examine the realm of possibilities not only from a lender’s standpoint, but also a producer or managers standpoint.

The opinions of Dr. David Kohl are not necessarily those of Farm Progress.

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