Introduction
A contingency plan is a course of action to help a business determine how to respond to possible future events. Contingency plans are often referred to as “Plan B”. One of the most common contingency plans used by small businesses relates to how to respond to the departure or absence of key personnel. Contingency plans related to how to respond to changes in projected cash flows are also important. This article discusses cash flow contingency plans and describes how to use scenarios when building these plans.
Sources and Uses of Funds
In addition to providing a mechanism for reporting how a farm’s performance during an accounting period was influenced by major funding activities, sources and uses of funds statements are useful when developing contingency plans. Specifically, this statement can be used to examine whether a farm has sufficient cash flow from the farm to repay debt and purchase assets. An example of a sources and uses of funds statement using historical data is illustrated and described in Langemeier (2020).
In the current context, we are using pro-forma sources and uses of funds statements to project net cash flows and ending cash balances. The five primary categories of sources and uses of funds statements 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 (e.g., family living expenditures), and income and self-employment taxes from cash farm receipts. If these cash flows are positive, they can be used to repay debt, provide a down payment for machinery or land purchases, or build up cash reserves. 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 this case, cash flows from operating activities and/or cash flows from financing activities will need to help pay for the 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. Conversely, if principal payments are smaller than loan receipts, cash flows are positive.
When net cash flows are relatively small compared to cash receipts, it is important to think about how the farm will make its principal payments on machinery, buildings, and/or land loans. At times, net cash flows from operating activities are not large enough to fully cover principal payments. In this instance, the farm needs a contingency plan. For example, some farms hold enough working capital, in the form of cash and current assets, such as crop inventories, to cover one or two years of shortfalls. Another strategy may be to borrow against land that is owned. Obviously, a farm would need to be careful when using this strategy. Borrowing against land that is already owned will increase principal payments in subsequent years.
Developing Scenarios
Scenario planning is a tool for ordering one’s perceptions about alternative future environments in which one’s decisions play out. The purpose of using scenarios is not to predict what is going to happen. Rather, scenarios can be used to ask “what if” questions. Scenario planning is particularly useful in an environment that is very uncertain with a range of possible outcomes. An example can be formulated using the continency planning discussion above. If price or yield is 10 percent lower than projected, would our farm have enough net cash flow from operating activities to repay principal payments? On the positive side, if price or yield is 10 percent higher than projected, would net cash flow be high enough to replace one or more pieces of equipment?
When using scenario planning, it is important to carefully think about the number of scenarios that you would like to analyze and how many variables you will change at a time. Here are my recommendations. As far as the number of scenarios is concerned, it is difficult to effectively analyze more than three scenarios. Using the following generic scenarios often works well: worst-case scenario, most likely scenario, and optimistic scenario (e.g., best case). I have also found that changing more than one variable at a time makes it difficult to disentangle the contributions to net cash flows arising from each individual variable. Therefore, I recommend changing only one variable at a time. The variable of interest depends on an individual farm’s situation. For farms that sell on the open market, crop price is often used to formulate the scenarios. Farms with contracts that specify price may want to use yield (i.e., weather) or the loss of one or more of your key contracts or buyers as the variable of interest.
Conclusions
This article discussed the use of contingency planning to project cash flow and repayment capacity. As cash flows from a farm operation become tighter, it is necessary to find other funds to help pay for asset purchases or delay asset purchases, and to repay debt. Budgeted expenses can be used along with scenarios pertaining to crop price and yield to determine how sensitive a farm is to not being able to repay debt or purchase assets. Contingency planning is an important first step in ensuring that a farm will have enough working capital to make it through low net cash flow years and that a farm will have sufficient funds, in the long run, to repay debt and replace assets in a timely manner.
Additional Reading
Langemeier, M. “Sources and Uses of Funds Statement.” Center for Commercial Agriculture, Purdue University, August 2020.
Schwartz, P. and D. Randall. “Ahead of the Curve: Anticipating Strategic Surprise.” In Blindside: How to Anticipate Forcing Events and Wild Cards in Global Politics.” Washington D.C.: Brookings Institution Press, 2007.