Linda Benedict | 10/30/2004 12:35:44 AM
Lonnie Vandeveer, Kurt Guidry and Manuel Filipe
Changing economic variables and business conditions increase the need to manage farm income and risk. Financial performance is measured in terms of profitability, risk and the ability of the business to pay bills on time (liquidity). Farmers can increase their profits by using selected pre-harvest marketing strategies instead of selling in the cash market at harvest.
To illustrate the differences that pre-harvest marketing strategies can make, the following comparisons were made based on a representative grain farm in central Louisiana that includes 1,000 acres where corn and soybeans are produced. An optimal marketing pre-harvest strategy estimated from an economic model is compared to a typical cash marketing situation.
The Louisiana Farm Bureau Marketing Service, along with Louisiana Cooperative Extension personnel, was used to select three pre-harvest marketing strategies. These strategies were:
Sell in cash market at harvest—still the most popular method in Louisiana. The producer gets whatever price is offered at harvest.
Initiate a pre-harvest forward price contract—becoming more popular in Louisiana. The producer locks in a price before harvest.
Use a pre-harvest hedge-to-arrive price contract—also becoming more popular. The producer locks in a price based on the futures market, but there is still time before harvest to go up or down with the final, total price.
The model first estimates the optimal pre-harvest marketing strategy for each commodity. The optimal pre-harvest marketing strategy is then used to estimate the optimal crop production portfolios for the whole farm. Marketing Strategies Data from the marketing service were collected, and summary statistics for each of the crops for the period 1986 to 1999 are presented in Figure 1.
For corn, the first marketing alternative is represented by the cash price on the first Monday of August, the forward contract price is represented by the price on the first Monday of the second week of April, and the hedge-to-arrive contract is established by the price on the first Monday of the second week of April and the basis of the first Monday of the first week of July for the August futures price. Both Farm Bureau and LSU AgCenter commodity specialists were consulted in selecting these marketing dates as representative of area farm marketing activities.
For soybeans, the first marketing alternative is represented by the cash price on the first Monday of October, the forward contract price is represented by the price on the first Monday of the second week of April, and the hedge-to-arrive contract is established by the price on the first Monday of the second week of April and the basis of the first Monday of the first week of July for the October futures price. Again, these dates are representative of typical marketing activities by area farms.
Price distribution data shown in Figure 1 reveal differences in mean prices for alternative marketing methods. The mean price for corn in the cash market is estimated at $2.60 per bushel, while this estimate for the hedge-to-arrive contract is $2.77. The mean price of soybeans in the cash market is estimated at $6.14 per bushel, whereas this estimate for the forward contract is $6.39 per bushel. These estimates generally indicate the potential of using pre-harvest marketing strategies to improve farm financial performance.
The representative farm in this study included a capital structure of $666,841 in equity capital and $422,159 of debt capital. Government payments were estimated at $65,340. In addition to enterprise production expenses, which were used in estimating the rate of returns to assets, other expenses included farm overhead of $26,900, operating interest of $5,445 and family living costs of $25,000. The interest rate was 9 percent, and the income tax rate 20 percent.
Optimal Marketing, Production Portfolios
A safety-first decision economic model was used to estimate an optimal marketing portfolio and optimal production portfolios. This model assumes that decisions are made to minimize the probability of economic losses. Results presented in Figure 2 indicate that the rate of return to assets for corn for the cash marketing scenario is 8.87 percent, while this amount for the optimal marketing scenario for corn is 10.39 percent. Similarly, for soybeans, the mean rate of return to assets is 8.21 percent for the cash marketing portfolio, whereas it is at a higher amount of 8.66 percent for the optimal marketing portfolio.
The results suggest that the hedge-to-arrive contract best fits the corn enterprise, while the forward contract is estimated for soybeans. The optimal marketing portfolio for corn includes 24 percent cash and 76 percent hedge-to-arrive marketing strategies. The optimal marketing portfolio for soybeans includes 37 percent cash and 63 percent forward contract marketing strategies. Selling minimal amounts of each enterprise in the cash market for each optimal portfolio reflects modeling constraints for not contracting more of the commodity than can be produced in any given year.
The optimal enterprise production portfolio was estimated for both the cash marketing scenario and the optimal marketing strategy scenario. The optimal production portfolio with cash marketing includes 39 percent corn production and 61 percent soybean production. With the optimal marketing portfolio, corn increases to 46 percent and soybeans fall to 54 percent.
Financial data along with production portfolios were used to estimate debt repayment capacity for optimal and cash marketing scenarios using the economic model. It is assumed in this analysis that the producer wishes to meet all of the farm’s financial commitments in nine of 10 years. Model results indicate that debt repayment capacity is greater for the optimal marketing scenario than for the cash marketing scenario. Assuming the representative farm must meet all of its financial commitments in nine of 10 years, maximum debt repayment capacity for the optimal marketing scenario is estimated at a debt-to-equity ratio of 0.64, whereas for the cash marketing scenario, it is estimated to be 0.51.
Other financial performance estimates for the cash marketing and optimal marketing strategy are presented in Figure 3. Profitability, risk and liquidity financial indicators shown in Figure 3 indicate that the optimal marketing plan is financially better than the cash marketing alternative. In terms of profitability, the optimal marketing scenario offers a profitability level of an 8 percent rate of return to equity, whereas this rate for the cash marketing alternative is 6.72 percent.
The optimal marketing strategy is not as risky as the cash marketing scenario. The standard deviation, which provides a measure of variability and risk, is estimated at 6.25 percent, whereas it is estimated at 5.98 percent for the optimal marketing strategy. Moreover, the probability of meeting all cash commitments in nine of 10 years is estimated to be 0.91 for the optimal marketing strategy scenario, whereas this same estimate for the cash marketing scenario is estimated at 0.72. This means that the representative farm meets all of its financial commitments in approximately seven of 10 years with cash marketing, and the farm is estimated to meet all of its financial commitments in approximately nine of 10 years with the optimal marketing strategy.
Liquidity in this article relates to the ability of the farm business to pay its bills on time. Liquidity for the representative farm is measured as the sum of the dollar returns to equity capital and the dollar amount of unused credit expressed in terms of equity. As shown in Figure 3, liquidity is estimated at 8.44 percent of equity capital ($56,281) for the optimal marketing strategy scenario, while it is estimated at 6.72 percent of equity capital ($44,812) for the cash marketing scenario.
Pre-harvest Strategies Boost Profitability
This article generally shows how different marketing strategies affect farm financial performance on a representative Central Louisiana corn-soybean farm. One important financial variable includes debt-carrying capacity, where the amount of debt is measured by the debt-to-equity ratio. Results of the analysis indicate that optimal pre-harvest marketing portfolios have a larger estimated debt-carrying capacity than the cash marketing strategy.
The results also indicate that different pre-harvest marketing strategies affected profitability, risk and liquidity on the representative farm. Both profitability and liquidity were higher for the optimal marketing scenario than for the cash marketing scenario. Similarly, the results indicate opportunities for improved farm risk management. Marketing the crops at harvest in the cash market has the highest level of risk. Moreover, if a portfolio of pre-harvest forward price contracts along with the cash market are used, the farm was able to meet all of its financial commitments within its desired limits of probability (nine of 10 years). These results illustrate a direct relationship between marketing strategies and financial performance. Improved marketing is expected to provide more and better opportunities for risk and financial management within the farm firm.
(This article appeared in the summer 2003 issue of Louisiana Agriculture.)