Budgeting basics: Do you know your real annual profit?
With a new season fast approaching, do you already know which are the biggest expenses of the year that you should consider cutting down? Have you identified which crops are profitable to grow and which ones create loss? Read forward to answer those questions.
After planning the cropping, fertilisation, and agrochemical tasks for the coming harvest season, consider the farm budget next. While the main decisions for the next season are made by analysing the past season, the foundation for a positive bottom line is laid with a stress-tolerant budget plan.
But what is a budget and what are the metrics farm owners should follow to guarantee profitability?
Many farmers using eAgronom have reported increased profits even without EU subsidies. We started researching those successful farmers and found them having a clear overview of both their agronomical end-results and financial situation.
We’ll cover the following in this article with important budgeting terms you will come across:
What is the budget?
The budget is the financial plan of a business for a specific period. Ultimately, the person responsible for the budget is the owner of the company who may be assisted in its production by the CEO, the CFO, and various specialists (agronomist, head of repairs, etc.).
In crop production, the ideal budget is based on the harvest year it will run from — when the first crops are sown until when they are harvested.
We spoke with several farmers to better understand how they plan their budgets in practice. Talking with farmers, we found that no two farmers do a budget in the same way. However, any version should match the harvesting season, set for a specific period.
We combined the real-life examples with recommendations from farming experts to come up with a farm budget sample that all farmers, both large and small producers, can recognise and find straightforward to use.
The income and direct costs (seeds, crop inputs, depreciation, interest payments) are for the harvesting season, which is from cultivation to harvest, and indirect costs (e.g. annual payroll forecast) are usually based on previous year reports.
In this way, the budget is connected to real data and reflects the true profitability of the farming (harvest) year. This information can be the primary basis for cash flow and associated management accounts.
Example of a simple Budget plan:
- Income from sales and subsidies: 800 €/ha
- Cost of seeds, fertilisers, and agrochemicals: 250 €/ha
- Cost of fuel, salaries, services, administrative, etc. operating costs: 250 €/ha
- Machine and property depreciation: 100 €/ha
- Loan interest payments: 10€/ha
- Net profit = 800 – 250 – 250 – 100 – 10 = 190 €/ha
When should I develop the budget?
Although our research shows that most farmers using eAgronom develop their budget from October to January, a preliminary budget should be developed before sowing the first crops of the harvest season. Therefore, the ideal time to start the budget is in May or June, ready for the next harvest season.
The budget can then be adjusted in November and confirmed at which point the crop plan is more certain and there is more up-to-date intelligence regarding resource costs and crop sales values. In November, the results of the previous season are known and this will help fine-tune the next season’s budget. Most importantly, calculating the cash requirements for the next season.
Wait, but why should I plan the Budget ahead at all?
Generally, businesses that have a detailed budget, management accounts, and cash flow packages are more cost-effective. But here are what farming experts say:
- The budget plan shows you whether your planned cropping is likely to be profitable or not, and allows you to play with various cropping scenarios to see which gives the best return and importantly is sustainable in the long term.
- By virtue of the associated management accounts (what actually happens on the field and in the business), a budget gives you a strong financial control of your business.
- A farm budget should clearly identify the cash needs for the business and most importantly what drives the cash flow.
- A planned budget allows you to produce a more accurate forecast for the business as it can be updated as a “live” budget forecast as the season progresses and more is known of costs, yield potential, and sales prices.
- Accounting for the flow of income and expenses allows you to accurately plan all the resources needed to service the business for the harvest year and is a huge aid when ordering inputs.
- A well-structured budget always impresses the bank, it provides an important part of the financial detail required when applying for a loan. It generally makes the whole process of negotiating with banks run smoother, with a higher likelihood of getting your application accepted.
Everything to know about budget planning
Farm owners are in the farming business normally with one big goal — to earn profit. After all, this is what doing business is about. However, understanding the important metrics in your financial flows can help minimise risks and secure profits even in stressful conditions.
1. Gross Margin
The first metric to keep your eye on is the gross margin.
The Gross Margin provides a simple method for comparing the performance of enterprises that have similar requirements for capital and labour. A Gross Margin refers to the total income derived from an enterprise less the variable costs incurred in the enterprise. Gross margin is calculated on a crop-by-crop basis as it is particularly useful for comparing inter-crop performance and identifying which crops are really contributing to profit.
To know the gross margin, you need to know the Income and Direct Input costs.
For eAgronom users, the data that makes up Gross Margin is already filled in during the planning of the next season (e.g., seeds, fertilisers, sprays).
Today, grain producers receive income from two main sources, selling the produced grain and various EU subsidies. EU subsidies cannot be guaranteed for the future, so the aim should be to attempt to budget so that the business is profitable without this addition. In fact, multiple eAgronom users have already been profitable without EU subsidies for multiple years in a row and continue to grow their profits.
In eAgronom, the sales revenue is calculated on a crop-by-crop basis from the area planned for each crop, forecast yield and expected sales price.
While the cropping is to a degree set by the rotation, the planned yield should be the average of the harvested yield within the past five years.
During the research, we often saw farmers being overly optimistic with their yield expectations. Farming is a risk management business and the professional farmer always budgets on a realistic yield. Thus, avoiding nasty surprises at the end of the season.
While the sales price is somewhat dependent on the global market prices, many farms contract with buyers up to a year ahead to fix prices for a proportion of the expected yield. The more expected production is fixed with the buyer the more precise the budget is. Notably, banks tend to give lower interest rates to farmers who are realistic and can show that the estimated prices are fixed on a contract.
To note, not all the crops are sold on the market but can be used as seeds in the next harvesting season or as feed for your livestock. Nevertheless, we recommend putting a price tag (market value) for these crops as well. In the end, the production is an important part of your annual output whether you sell it or use it for your own. This allows for accurately comparing crop production costs with gross margins.
The farming income does not include money received as loans or other financial instruments.
1.2 Direct Input costs
These include the Seeds, Fertilisers, and Agrochemicals, that will be used in the harvesting season. They are budgeted in quite some detail on a crop by crop basis with the eAgronom system. The product quantities are automatically aggregated by eAgronom from the drilling, fertilisation and spraying tasks planned for the next season. The estimated purchase prices can be taken from the pricing lists of local chemical resellers and/or agents. Again, it can be worth considering fixing the prices with the reseller with a contract, this can guard against price rises or shortages of the product later in the season and importantly brings an element of risk management into your business.
Gross Margin = Income − Direct Input costs
2. EBITDA = Gross Margin – Indirect Production costs
The metric that shows the cash generated by your farm is internationally called the EBITDA.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a metric used to evaluate a company’s operating performance. EBITDA can be seen as the indicator of cash flow from the entire company’s operations.
To know the EBITDA, you need to know the Gross Margin and Indirect Production costs.
2.1 Indirect Production costs
These can be viewed as the costs that are incurred to grow all the crops in the rotation for the harvest year. They include:
- Machinery maintenance
- Property maintenance
- Land Rental
The costs are indirect because it is not practical or of any real value to plan or allocate all these expenses by exact crop and field and are almost impossible to report accurately in such detail in management accounts. The exception to this may be diesel, which some businesses may class as a direct cost.
Thus, normally these total costs are spread over the whole farm hectares. The costs can be simply calculated by looking at the previous year results (e.g., when the total payroll was 100.000 the last year, then it will be 100.000 plus/minus a margin depending on, say, the number of workers). Or it can be far more detailed by building up from a blank sheet. Building from a zero base for the first year of budgeting is always a good idea and certainly makes the budget more accurate and avoids many nasty surprises.
3. Operating profit (EBIT) = EBITDA – DA
EBIT stands for Earnings Before Interest and Taxes (EBIT). It is a company’s net income before income tax and interest expenses have been deducted. As one of the biggest expenses in farming business is the depreciation of machinery, EBIT is used to analyse the performance of a company’s core operations.
To calculate the EBIT, you need to know the Depreciation and Amortisation costs.
For eAgronom users, these costs are automatically calculated from the company’s list of machinery and properties.
3.1 Depreciation and Amortisation (DA)
A large non-cash expense for the farm is the depreciation of machinery and to an extent, the amortisation of properties. Tractors, harvesters, and implements (even when well-maintained) reach a point in their lifespan when reduced reliability becomes a real risk to the business. At this point, the machine is normally replaced.
Most businesses depreciate their equipment over a 7-year-period. As the value of machinery is decreasing, this is counted as a non-cash cost in the financial statement. In effect, depreciation builds up a cash fund within the business ready to fund the purchase of the new machine.
4. Net Profit = EBIT – Interest costs
The main metric that all businesses need to follow is the Net Profit.
Net Profit also referred to as the bottom line, net income, or net earnings is a measure of the profitability of the business after accounting for all costs and taxes. It is the actual profit!
To calculate the profit, you need to calculate the Interest costs you will pay in the next year.
4.1 Interest costs
Financial obligations to the bank are subject to interests. There are 3 main types of obligations:
- Long-term loans: The long-term obligations are usually loans for buying land or building a new building.
- Short-term loans: Loans that are taken to fulfil periods of negative cash flow during the season (before harvest is sold).
- Capital rent: A loan for buying a tractor or other machine.
Importantly, lease-purchases are considered operating costs and do not reflect in the financial costs account. To note, as loans are not included in income, the principal payments are not included as a cost. The only financial costs in the budget are the interest payments, both the receiving of loans and the repayment of loans only affect cash flow, it is only the interest that affects the profit and loss accounting of an Agribusiness.
The Tax part of the budget is highly dependent on local country tax rules. As in many EU countries, there is no income tax (or corporate tax) on business profit.
More budget considerations
Crop production costs (COP/t)
Crop production cost gives an overview of spending on a tonne of production (€/t). In the industry, it is referred to as COP/ T (Cost Of Production per tonne).
Adding to the equation, the expected selling price enables comparing different crops’ profitability. For example, if your COP/t is €150 and the selling price is 160 €/t, your profit will be 10 €/t.
eAgronom does these calculations for you automatically. Here’s what you will get from eAgronom (June 2019):
Useful for getting loans from the Bank
Most farmers require a short-term loan (annual) from the bank for working capital to fund business operations during the season. Additionally, longer-term loans (>1 year) for buying machinery, land, or to develop new enterprises in their business may be necessary.
We talked to banks and asked what they need from farmers. In addition to the past 5-year income statements and the next season’s budget, banks are interested in multiple metrics that farmers themselves have rarely heard of.
- Debt: The total amount of loan owed to the bank at the end of the year.
- Debt/EBITDA: The coefficient that tells how many years it would take to pay back the debt.
- TDS (Total Debt Service): Sum of the loan principals and interests paid during the budgeting year excluding principal payments of short-term loans.
- DSCR = EBITDA/TDS: Coefficient that shows business tolerance to the loan stress.
Having a prefilled budget accelerates the loan process at the local bank from months to weeks. Usually, farmers with a solid financial plan also get lower interest rates and seasonal offers.
The budget plan is a crucial step in farm management for providing a better financial overview for farmer-owners and agribusiness operators. In a famous saying, the early never borrows from the late!! We encourage you to start planning the upcoming season’s budget as early as possible!
eAgronom equips users with an array of powerful farm management tools to assist in steering and fine-tuning their profitable business enterprises.
Start your eAgronom journey in here
- Kristjan-Julius Laak (eAgronom product owner)
- Simon Boughton (Agronomical advisor)
Last updated: 8 December 2021