There are three basic questions we need to consider in regard to managing money in our ranch businesses:
- Is it profitable? (economics)
- How will I pay for it? (finance)
- What are the tax consequences?
This is the order in which we should ask the questions. If a venture isn't profitable, financing is irrelevant. Financing a losing proposition makes no sense.
If the business is profitable, and we've created adequate cash flow, then we should take steps to minimize taxes.
Too often, though, we ask these questions in reverse order. And, in our efforts to minimize taxes, we make questionable economic or financial decisions.
Sometimes, financial constraints limit economic opportunities. For example, if an investment pays big dividends several years from now but doesn't provide short-term cash flow, we may find it hard to put food on the table now.
Frequently, the constraints are self-imposed and result from either not recognizing the time value of money or not being willing to manage cash flow.
Here's an example. A rancher recently told me he needed to maintain a spring calving herd and a fall calving herd so that he had income twice a year instead of once a year. He acknowledged it would probably be more profitable to shift to one herd, but he said he needed income twice a year to make his loan payment.
This isn't a problem of two paychecks versus one. The problem is ignoring the time value of money and failing to manage cash flow.
Which would you rather have: $120,000 today or $10,000 a month for the next 12 months?
Using simple interest at a rate of 10%, the $120,000 paid today would be worth $132,000 a year from now. Meanwhile, the $120,000 paid over the next 12 months in equal installments would be worth about $125,500 at the end of the year.
I'll take the money up front, please.
Managing cash flow begins with creating a cash flow budget that projects income and expenses for the year. A good time to prepare the budget is after weaning and pregnancy-checking in the fall.
At the Ranching for Profit School, we teach participants how to construct a cash flow including one income column per enterprise, several columns for overhead costs, several for direct costs and at least one for capital expenses (see Figure 1).
We use four lines for each month. The first line is to record the budget for each income and expense item. The next line shows the expense for each item that was actually incurred that month. This should be completed as soon as figures are in for that month.
The third line shows the difference between the budget and the actual expenses for that month. The fourth line records the cumulative difference between the budget and actual expenses for the year to date.
A cash flow report clearly shows periods of cash surplus and shortage before they occur and can help you determine how to manage through these periods. It will help determine if, when and how to use short-term financing.
But cash flow is more than just a page of income and expense figures. At the Ranching for Profit School, we refer to cash flow as “the minutes of the production meeting, written in dollars and cents.”
The plan communicates precisely to partners and workers what is planned. It shows when you expect sales to occur and when you anticipate making major purchases. It also will help you determine the tax consequences of your plans well before the taxes are due.
The cash flow plan is more than just a budget. In fact, the greatest value of the cash flow is not the plan itself but the process of completing it. The thought that goes into assessing various management alternatives is much more important than the sheet of paper (or the computer screen) that holds your projections.
The cash flow is also a monitoring tool. By updating it each month to show the actual movement of cash into and out of the business, you have a red-flag warning as soon as the actual income and expenses significantly deviate from the budget. Used this way, the cash flow becomes an essential tool if you are ranching for profit.