|
|||
|
|
||
|
|
|
|
|
|||
|
|
||
Risk Management Sample LessonRM006 Finding and Using Risk Management Information
Gathering information is a part of the first two steps required in making a management decision. The first step is to become fully aware of what risk problems you are going to face. The second step is to gather the facts you will need to understand and manage those risks. UNDERSTANDING YOUR RISKS In earlier lessons you have learned about many types of risks everyone faces, as well as some specific risks in production agriculture. Deciding how to manage each of those risks may require a different set of information. For example:
A review of what is meant by "risk management" will also help you to understand what kinds of information are needed. In general, risk management means using strategies that greatly reduce the chances you will be forced out of business. It also means reducing the chances that your profits and/or your financial position will drop below some unacceptable level. Notice that "managing" risk does not mean "eliminating" risk. In many cases, "taking risk" is necessary to earn a profit. If there were no risk in a profitable enterprise, it would soon attract so many producers that profits would vanish under a flood of surplus output. Meanwhile, enterprises that are the most risky often offer the largest profits. Over time, markets reward business managers for taking risk. To make a sound risk management plan, you will need information that will help you to keep risks in balance. Excessive risk that puts your business in jeopardy needs to be avoided, while some risk taking is needed for long-term growth. TYPES OF INFORMATION If you were making a risk management plan for a farming operation, you would need to gather information from two types of sources: 1. Internal sources: Internal sources include all the facts you need to know about your own business. This includes such information as your acreage, numbers of livestock, yield records, financial statements, cost records, etc. To get started on risk management, farmers are encouraged to look back over records of net farm income, crop yields, grain prices received and government payments. Some facts could also come from tax records for the past several years. It also is helpful to have annual cash flow and financial balance sheet statements. Farmers who have kept good records over the years will find it much easier to make risk management decisions than those whose records are incomplete. Trying to manage risk is likely to encourage more farmers to start keeping more records. 2. External sources: External sources are needed to get facts about things that happen outside of your business. These are events over which you have no control, but they do have an impact on the success of your business. External information includes market prices, weather, economic conditions and interest rates. It also includes the cost of items such as feed, fertilizer, fuel and taxes, as well as the cost of insurance policies used to shift risk. Much of the external information you will need is factual, such as current and past price levels. Some of it, however, must be in the form of estimates and forecasts. For example, USDA crop and livestock reports are estimates based on surveys. USDA supply and usage projections are a type of forecast. External sources of information are not hard to find. There is a huge amount of information available about U.S. agriculture. In addition, much of it is broken down by state, and some is even available by county. Sources include agencies of the USDA, extension services and experiment stations at Land Grant universities, and private firms. In addition, the information is easy to get. Extension services have county and regional offices, as does the USDA Farm Service Agency. Much information is published and is available by mail. In addition, huge amounts of agricultural information is now available at numerous Internet sites. The only real problem in finding external information is the danger of being buried under too much of it. The challenge is to select and organize only those facts that you will really need to make your decisions. Too often, a manager can fail by getting bogged down gathering more and more facts without reaching a conclusion and taking action. QUESTIONS TO ASK A useful way to narrow your search to what you really need is to start with a set of specific questions you need answered. Then you can zero in on those facts and avoid wasting time on anything else. For most risk decisions, your questions can likely be narrowed down to four basic issues:
These four questions are worth remembering. They are key to nearly every risk management decision you may need to make. FINDING ANSWERS One way to organize your search is to consider each risk separately. Here are some examples of how you might find answers to the previous questions for three areas of risk faced by a typical farm operator. Production risk: What are the chances of a loss? Look at your yield records. What have been your average, high and low yields per acre for the crops you grew over the past 10 years? If you do not have records for your farm, what have been the highs, the lows and the average in your state or your county? What is the likely cost of that risk? You can look at high, low and average net income from your crop enterprises over the past 10 years. Or you could use state or county price and yield records for 10 or more yields to make estimates. What can you do about your yield risk? How much could it be reduced with drought resistant varieties or precision farming methods? What would that cost? What crop insurance alternatives are available? What are the premium costs? Market risk: What is the size of your risk? Look at the average, extreme high and low prices you have received for your individual crops for the past five years or more. What was the average price received for each year's crop? The price you receive can be the result of three market elements. Thus, to make a logical price risk management decision, you will need information on all three market elements. They include: futures prices, the basis and possibly the spreads or difference in the nearby and deferred futures prices. What will it cost to shift your risk with a contract or futures hedges? Hedging requires brokerage fees and interest on margin accounts. Those costs are small, however, compared with the opportunity cost. By protecting against downside risk, you give up the opportunity offered by higher prices. Financial risk: What are the chances that your cash flow needs will not be met in the year ahead? Will there be bills you will not be able to pay on time? A record of month-by-month cash flow over the past year and the past five years can help you find answers. So can the facts you have gathered on production and market risk. With those facts you will be able to make a cash flow projection for the year ahead. If you are just starting out and do not have records, you will need to depend entirely on projections of expenses and potential revenue. When during the year will you need credit? How much will you need? Where will you get it? How much will it cost? Answers to these questions will come from discussions with lenders in your areas. But first, you will need to have facts about your business and a business plan. Lenders will want to know how the loan funds will be used and how loan payments can be met. You will need a business plan with cash flow projections to help answer their questions about how you will meet your payments. Lenders will also want to know all about what you own and what other debts you may owe. Lenders may want you to place a lien on property you own in case you are not able to make payments out of your cash flow. In that case, you may be required to sell assets in order to pay off debts. EXERCISES: Discuss in class and/or write answers to the following for your teacher. 1. Select a crop that is important to producers in your area. Get records of average state or county yields per acre for that crop over the past five years. Calculate the five-year average yield and compare it to the highest and lowest yield. Based upon the five years of data you have, what are the chances that the next year's yield will be above or below the five-year average? 2. Find a monthly harvesttime average price for the crop you selected in Exercise #1 for the past five years. Calculate the five-year average price and compare it to the highest and lowest price. Based upon the five years of data you have, what are the chances that the next year's price will be above or below the five-year average? 3. Assume you are a farmer growing the crop you selected in Exercise #1. It is midway through the growing season and it appears you will be able to harvest a yield of at least the five-year average. Thus your production risk now appears very low. Meanwhile, the market price situation remains very uncertain, but you have an opportunity to sell your crop under contract for a price about equal to the five-year average. If faced with this kind of situation, what would you do? What facts would you use to make your decision? Explain how you would use those facts.
INTERNET RESOURCES:Internet sites that can provide facts needed for exercises include:
** USDA Economics, Statistics and Market Information System - Crop Production Annual Summary
** USDA Economics, Statistics and Market Information System - Agricultural Prices Internet sites about recordkeeping systems include:
** University of Minnesota - Center for Farm Financial Management
** Finpack Information
** Red Wing Software TEST: 1. Sound risk management is made up of strategies that will help to eliminate as much price and income uncertainty as you can. TRUE or FALSE?
2. Sources of facts and information needed to manage the risk of operating a farm business can be divided into what two types: 3. While accurate facts are important to sound risk management, trying to gather too much information is also a mistake. TRUE or FALSE?
4. What four important questions need to be answered to manage a risk? 5. Using farm records is a more accurate way to judge production yield risk than going to county or state yield records. TRUE or FALSE? Explain your answer.
----------------------------------------------------------------------------- END STUDENT SECTION RM006 Finding and Using Risk Management Information
TEACHER'S GUIDEOBJECTIVE: Students will be able to list internal and external sources of information used for agricultural risk management. In addition, they will be able to list and discuss four basic questions that need to be answered to arrive at risk management decisions. PREPARATION: Be ready to discuss alternative sources for various types of information discussed in the lessons. Several lessons from the AgEdNet.com Marketing Library may also be helpful, especially MK201 Finding Grain and Cotton Market Information and MK251 Finding Livestock Market Information. INTERNET RESOURCES: Internet sites that can provide facts needed for exercises include:
** USDA Economics, Statistics and Market Information System - Crop Production Annual Summary
** USDA Economics, Statistics and Market Information System - Agricultural Prices Internet sites about recordkeeping systems include:
** University of Minnesota - Center for Farm Financial Management
** Finpack Information
** Red Wing Software IMPORTANT TERMS: assets, basis, debts, cash flow, external sources, internal sources, lien, opportunity cost, risk, spreads, uncertainties, yield. EXTENSION: Assign teams of students to do research on accounting and recordkeeping services being provided to farmers in your area. What records do they help farmers keep? How are the records kept? These may include consulting firms, accounting services, record associations and computerized record systems. In addition, you may want to ask one or more teams to search for Internet sites with information about recordkeeping systems available to farmers. Some useful sites they may want to check are listed under Internet Resources above. EXERCISE ANSWERS: 1. A rough estimate of the chances of a higher or lower than average yield can be made by counting the years above average or below average. The chances can then be expressed in a percentage above or below. For example, with two years above average and three years below, the percentage chances are 40 percent above average and 60 percent below average. This method is the most accurate if all of the five years are somewhat typical. It becomes biased if one or more of the years are highly unusual. For example, a year with the worst drought in 20 years would greatly bias a five-year sample. 2. Use the methods from exercise #1 to find your answer. 3. Student answers are likely to reflect personal feelings about taking risk. In addition, a farmer in this situation may first want to look at crop and market outlook forecasts. What are crop conditions in other areas? Is there likely to be a shortage or surplus of the crop? How much carryover crop remains? What do USDA usage estimates show? What are forecasters predicting for prices at harvesttime? All of this information would be useful in making a decision. The facts available could also be used to look at the decision in terms of the "opportunity cost" of contracting. Let's say the numbers show that there is a 60 percent chance that prices will be above the average. The chances are three out of five that prices will end up above the contract price. The producer who has enough assets to survive below average prices is not likely to want to contract under those odds. The opportunity cost of contracting is greater than the downside risk. However, remember, this conclusion is based upon only five years of data. In addition, a producer who is carrying a large debt load may not be able to accept a year of below average prices. TEST KEY: 1. Sound risk management is made up of strategies that will help to eliminate as much price and income uncertainty as you can. TRUE or FALSE? FALSE. At times, managing risk includes taking known risks to gain the opportunity of a greater profit.
2. Sources of facts and information needed to manage the risk of operating a farm business can be divided into what two types: 3. While accurate facts are important to sound risk management, trying to gather too much information is also a mistake. TRUE or FALSE? TRUE. A manager can get bogged down searching for more facts without reaching a decision and taking action.
4. What four important questions need to be answered to manage a risk? 5. Using farm records is a more accurate way to judge production yield risk than going to county or state yield records. TRUE or FALSE? Explain your answer.
TRUE, in most cases if the farm records are accurate and are available for a period of years. A FALSE answer could be correct if there is doubt about the accuracy of the farm records. Also, more years of data from county records could also be used to check and improve the reliability.
END TEACHER'S GUIDE
To subscribe to AgEdNet.com or
for a "free trial", |
|
HOME | SUBSCRIBERS | VISITORS | ORDER | CONTACT US | TERMS & USAGE Copyright © 1995-2008 Stewart-Peterson. All Rights Reserved. STEWART-PETERSON and AGEDNET.COM are Registered Trademarks of Stewart-Peterson, Inc. AgEdNet.com®, a service of Stewart-Peterson, Inc. 137 South Main Street, West Bend, WI 53095 |
