Planning for Farm Expansion

Expansion has been commonplace for farm managers attempting to improve income. In 1969, the average size of a U.S. farm was 369 acres; in 1988, it was 463 a 25-percent increase in 20 years. The reasons for the popularity of expansion and the increased concentration of agricultural production into fewer but larger farms are many.

The continuing emergence of new, capital- intensive technology with strong economy-of-size features has been a principal reason. Such technology (for example, a larger, more productive tractor), once purchased, may not be fully utilized. Through increased use, fixed costs including depreciation, interest, property taxes, and insurance can be spread over more units, resulting in lower per-unit costs. Additionally, lower input prices and/or higher commodity prices may be available if volume is increased.

Government programs that stabilize prices and provide benefits based on volume of production also have encouraged farm expansion. Favored income tax treatment of capital gains and depreciable capital assets has reduced the cost of investing in additional land, machinery, buildings, and breeding animals.

In some cases, growth has occurred to more effectively utilize available management resources. Finally, if the per-unit revenue and cost relationship is favorable and constant at different levels of production, net income can be increased by producing more units.

Unfortunately, expansion has not always resulted in higher farm income. For some expanding farm businesses, poor timing resulted in falling profit margins (due to unanticipated rising costs, falling commodity prices, and/or crop failure). Other farm businesses were unable to cope with the management and labor challenges associated with a larger business. For some farm businesses, the debt incurred by expansion was excessive, overpriced, and/or inappropriately structured. And some farm businesses expanded too extensively or too fast.

Basic Planning

Effective planning, however, can improve expansion decisions.

Prerequisites for Planning. A prerequisite in considering farm expansion is for all involved parties to agree that a larger operation is a desired goal. Expansion often implies the assumption of added financial risks, less leisure time, and increased personal stress. If the involved parties are not willing to accept these challenges, no amount of planning and analysis is likely to assure a successful expansion program.

Another prerequisite for successful expansion is the absence of major business weaknesses. Pre-expansion problems often become postexpansion crises. A good record system is needed to identify weaknesses. A good record system permits the timely preparation of complete and accurate balance sheets, accrual income statements, cash-flow statements, and enterprise reports, as well as income tax information. Without a good financial records system, a manager is unlikely to have the understanding control of the business required to effectively manage a larger operation. (See Part III, Chapter 1 for more information on recordkeeping.)

With these prerequisites in mind, the next concern is planning the proposed expansion. Comprehensive planning is needed to convince all involved parties inside and outside the business that the proposal is financially acceptable. Planning efforts occur in two phases: (1) long-range and (2) transitional.

Long-Range Planning. The task of long-range planning is to evaluate financial performance when the expansion program has been fully implemented and is in full stride. This evaluation should include a financial analysis that addresses three key questions:Will the expansion be profitable?

(1) Will there be enough cash-flow?

(2) Are the risks acceptable?

The overriding concern about expansion is whether acquiring control of additional resources will generate a profit that is sufficient to compensate for the added risks. If expansion requires a major capital investment, profitability needs to be measured in terms of capital performance (for example, rate of return on the added investment). Expansion also may require a large increase in operator labor and management; it is important to determine if sufficient income will accrue to cover these personal resources.

Although profitability and cash-flow correlate highly, acceptable performance for one does not necessarily imply the same for the other; it is necessary to analyze both. A cash-flow analysis can determine whether the expanded business will generate sufficient cash revenue to meet its cash obligations in a timely manner. More specifically, determine if funds are available to pay operating expenses as well as income and Social Security taxes, to retire term (over 1-year maturity) debts, to replace depreciable assets as they wear out, to maintain a contingency reserve, and to provide an acceptable living standard.

Risk also should be addressed in a long-range financial analysis. The business' ability to withstand risk is referred to as its solvency position, measured by net worth and by the percentage of indebtedness (total debt - total assets). A higher net worth and a lower percentage of indebtedness imply stronger solvency and an increased ability to withstand risk. Thus, there is a need to consider the impact of expansion on the farmer's solvency or risk position.

Transitional Planning. If an expansion proposal passes the longer range profitability, cash-flow, and risk tests, it may be appropriate to conduct a transitional analysis. Even though the business is projected to perform satisfactorily once the expansion program is fully phased in, there may be problems in implementing the program. For example, a farmer who expands by adding a new enterprise may experience below-average yields until new production and/or marketing practices are mastered. Even expansion of existing enterprises may pose new challenges (for example, management of hired labor) and temporary substandard performance.

Thus, when the expansion proposal is substantial and the expansion is likely to involve accelerated costs and/or delayed income, a transitional analysis can be crucial to the success of the expansion. A transitional analysis typically estimates monthly, quarterly, or annual cash-flows during the period required to phase in the expansion program. The transitional analysis can reveal temporary cash-flow deficits and the need for additional financing. This information is essential to getting the right amount of capital at the right time.

The final phase of expansion management is monitoring and controlling the business as the expansion program is implemented. Records and transitional period cash-flow projections are key control tools. A comparison of actual cash-flows with projected cash-flows as the transition period unfolds may reveal discrepancies between the two. By comparing the two, the manager is in a position to quickly address an emerging problem before it becomes a crisis threatening the entire expansion program. Adopting appropriate risk control strategies is another means of reducing the impact of unexpected adverse developments. The exact nature of these strategies will vary with the type of farm and expansion program.

The Steins' Dairy Farm Expansion

Mr. and Mrs. H.O. Stein own and operate a dairy farm. The Steins have three children two sons, ages 22 and 16, and a daughter, age 18. The oldest son is about to graduate from college, is getting married, and wants to return to the farm after graduation.

The Steins' farm includes 140 mature cows and 160 acres of cropland. Mrs. Stein has a part-time secretarial job which earns her about $5,000 per year. As a result of 25 years of hard work and good management, the Steins are financially stable. However, the business is not large enough to provide adequate support for themselves, a teenage son at home, a daughter in college, and the graduating son and wife. Even though the oldest son's wife-to-be is assured of an off-farm job earning $15,000 per year, if the oldest son joins the business it will have to expand.

Goals Agreement. After several family discussions, agreement has been reached to allow the son and his wife to join the business, provided the proposed expansion program is financially feasible. A general partnership arrangement is desired with the son committing full-time to the dairy. Also, longer term plans are for the son to gradually acquire a financial interest in the farm's nonreal estate assets. The incoming son has agreed to initially limit his living withdrawals to $5,000 per year, recognizing that his wife is earning $15,000 from her off-farm job. Mr. and Mrs. Stein would like to have about $25,000 per year to support themselves and their two other children.

The Current Situation. No major weaknesses are apparent with the H. O. Stein business. Production records indicate the annual herd average is about 18,000 pounds of milk per cow. The Steins keep good financial records. The farm has realized a modest profit for several years and financial obligations have been met in a timely manner.

The Steins feel that expansion offers the best opportunity to increase income. An uncle who is a nearby farmer wants to retire and is willing to sell his 60-cow herd, plus replacement heifers, to the Steins for $81,500. Furthermore, the uncle has agreed to finance the sale with a 5-year loan carrying a 10 percent interest rate, to be repaid in five equal annual payments. Discussions with contractors and suppliers indicate an additional $94,440 is needed to expand housing, milking, feed storage, and manure handling systems. A loan officer at Farmers Bank, which has provided short- and intermediate-term financing for the Steins over the past 20 years, indicates a loan of $94,440 would probably have a 12-percent interest rate and a 7-year repayment period.