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Shock Testing Farm Financials

Dr. David Kohl
Educational Opportunities: 
Grain, Dairy, Swine, Beef
Home > Education & Events > December 2020 > Shock Testing Farm Financials

Hi, I'm Dr. Dave Kohl, Professor Emeritus, Agriculture Economics at Virginia Tech, and Academic Hall of Famer.

Today, I would like to talk about financial sensitivity shock testing. You know, we're getting at that time of the year where we're starting to plan for next year, and what is one of the big planning tools? Developing that projected cash flow.

One of the things that we're really seeing is volatility in the extremes. We've had the trade situation, we've had, of course, the pandemic, and then we've had closure of plants. So, one of the questions that I recently asked agriculture lenders, what are they doing as far as financial shock tests to projected cash flow?

Well, here are some of the thoughts. A few of them utilize the 5-5-3 sensitivity shock tests. That's a 5% decline in revenue, 5% increase in costs, and a 3% increase in interest rates. By the way, that came out of my book that was published decades ago called Weighing the Variable. I suggest, however, that we step up that game to the 10-10-3. In other words, a 10% drop in revenue, 10% increase in cost, and a 3% increase in interest rates.

Others were shock testing government supports and payments. In other words, what would happen to your bottom line? If we had a 25, 50, or 75% cut in government support? Or, what would happen if we didn't have the number of poultry flocks, or what happens if we have a layout from the integrator, or what would happen if we have a major processor shut down? These are the variables that you might put in to develop the parameters in operating your business 2021 and 2022.

However, financial shock tests are not only related to the cash flow. It's very, very important that we financial shock test our working capital. What happens at working capital drops by 25%? Or, let's go to the other part of the balance sheet. What happens if land values go down 20, 25%? How does this impact our overall equity position?

Again, financial shock tests are there to get us to critically think and one of the things is critically think about options A, B, C, and D. Well, we'll see you the next time and good luck in developing those cash flows and developing your financial shock tests.
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