A contingency plan is a course of action designed to help a business determine how to respond to possible future events. Contingency plans are “Plan B.”
Contingency plans related to how to respond to changes in projected cash flows are important. This article discusses how to use contingency plans to respond to cash flow shortages resulting from relatively low productivity or low commodity prices.
In addition to providing a mechanism for reporting how a farm’s performance during an accounting period influenced and was influenced by major funding activities, a “sources and uses of funds” statement is useful when developing contingency plans. Specifically, this statement can be used to examine whether the farm has enough cash flow to repay debt and purchase assets.
The five primary categories of a sources and uses of funds statement are: beginning cash balances, cash flows from operating activities, cash flows from investing activities, cash flows from financing activities and ending cash balances. Cash flows from operating activities are computed by subtracting cash farm expenses, owner withdrawals for family living, and income and self-employment taxes from cash farm receipts.
Cash flows from investing activities are computed by subtracting capital asset purchases from capital asset sales. If a farm is planning on purchasing assets, cash flows from investing activities will be negative. In other words, cash flows from operating activities or from financing activities must help pay for assets.
Cash flows from financing activities are computed by subtracting principal payments from loans received during the year. If principal payments are higher than loan receipts, cash flows from financing activities are negative. If principal payments are smaller than loan receipts, cash flows are positive.
Let’s use these cash flow definitions in an example. The farm wants to purchase assets of $150,000 later this year. There are at least four different sources of cash that can be used. It’s likely that a combination of these sources will be used.
First, the farm could draw down cash balances. This would reduce liquidity, which may not be prudent. Second, the farm could use cash flows from operating activities, assuming this number is positive. Third, the farm could sell other assets to help make the purchase. Fourth, the farm could borrow money for the asset.
Where do contingency plans come in? Suppose cash flow becomes relatively tight as the year progresses. Maybe crop prices are 10% below expectations. So, cash flows from operating activities may be relatively small. Under this scenario, should the farm go ahead and make the $150,000 investment? Given the cash shortfall, the answer is probably no. If the investment is made, the farm may need to borrow most of the funds. If you did contingency planning, your plan would already address this scenario.
As farm cash flows from the farm operation become tighter, it’s necessary to find other funds to help pay for asset purchases or delay asset purchases.
A tight cash flow situation also has implications on the farm’s ability to repay term debt. More information pertaining to financial management can be found on the Center for Commercial Agriculture website.
Langemeier is a Purdue University Extension agricultural economist and associate director of the Purdue Center for Commercial Agriculture. He writes from West Lafayette, Ind.