Investing In Iron: How Much Is Too Much?

A question that commonly comes up in our discussions with clients is, “What is the right machinery investment for my farm?” In our analysis we see a wide range of investment in iron which can have an impact on cash flow and, more importantly, net income of the operation. In order to illustrate this point we will look at three farms: Ima Steeladdict, E.Z. Dozit, Rusty Van Hole.

Ima Steeladdict loves shiny paint and is on the local dealers speed dial. He hates the thought of having to fix machinery and feels that timeliness of getting field work done is crucial to his bottom line. Steeladdict hates the idea of custom work and wants the ability to do everything himself in a timely manner. He does periodically do custom work for others as time permits.

E.Z. Dozit prides himself on a functioning line of equipment that rarely leaves him stranded but does demand regular maintenance and mechanic work. Dozit hires custom operators when needed and also does some custom work for others.

Rusty Van Hole is master mechanic and king of arc welding and the odd baling wire fix. Van Hole’s newest tractor is the same vintage as a fine wine and Powerful Pierre was in power when it first rolled off the dealer’s lot. Van Hole is an excellent mechanic and isn’t scared to call in custom work in the event of a major breakdown. He doesn’t risk custom work mostly because he can’t bring his shop with him on the job.

THE INVESTMENT RATIO

The mechanics of measuring the machinery investment in any given operation are relatively simple. We start with the total equipment investment, make adjustments for custom work and other enterprises such as livestock and then divide the number by the total acres to arrive at a dollar figure per acre and compare to gross revenue per acre.

The total equipment investment is taken off the balance sheet at fair market value. If a farm does custom work we remove a portion of the equipment investment that reflects the percentage of the total acres that are used for custom work for that machine.

For example if an operation owns a high-clearance sprayer worth $200,000 and it covers 20,000 acres a year, 10,000 of which are your own and 10,000 of which are custom done we would reduce the equipment investment by 50 per cent or $100,000. Other enterprises, such as a cattle operation, are dealt with by reducing the equipment figure by an amount that reflects the investment for that enterprise. This final figure is divided by the number of acres for your farm and that gives you a $/acre figure. The number used to measure the investment is the equipment investment per acre as a percentage of the average gross revenue per acre. This is important to reflect differences between regions and special crops that require more equipment investment but will also yield more revenue per acre.

Our experience has indicated that most farms range from 50 per cent to 200 per cent. For example in a area with a average gross revenue of $300 per acre the equipment investment ranges from $150 to $600 per acre, with risks and rewards at both ends of the spectrum.

DEPRECIATION RISK

For Steeladdict, with a machinery investment ratio of close to 200 per cent the risk is depreciation. Steeladdict’s production risk is greatly mitigated by his machinery investment. Field work is done in a timely manner and production is always maximized for the environment. In years of high production and prices, this can be money well spent.

The problem is depreciation is always there and in years when prices are poor and production is poor the depreciation cost per bushel is very high. Depreciation is sometimes a hard cost for a business to recognize until the equipment needs to be replaced. Depreciation has no impact on cash until the equipment needs to be replaced with a comparable unit.

AT THE MERCY OF CUSTOM OPERATORS

For E.Z. Dozit, with a machinery investment ratio of 100 per cent the risk is a balance of depreciation repairs, maintenance and custom work. Dozit’s production risk is reasonable given machinery investment. The benefit Dozit sees is flexibility to reduce costs in years of poor production. For instance, in a year when he has only a 20-bushel-per- acre crop his old combine can handle all his acres and his cost to own that combine is low. In years of high production Dozit has the risk that he is unable to get custom operators when needed.

PRODUCTION AND CASH FLOW RISK

For Rusty Van Hole, with a machinery investment ratio of 50 per cent the production risk is extreme. In years of poor production Van Hole’s costs are minimized, however in years with high production potential, Van Hole is not likely to realize that potential. His other risk is high repair and maintenance which can have drastic impact on cash flow and profitability.

In summary, each of these three chaps are comfortable with their situation. The important part is that they are conscious of the risks that their machinery investmet ratios bring. They may choose differently in the future based on goals and stage of their farming career.

AndrewDeRuyckandMarkSloane managetwofarmingoperationsinsouthern ManitobaandarepartnersinRightChoice ManagementConsulting.Withover25years ofcumulativeexperience,theyoffersupport infarmmanagement,financialmanagement, strategicplanningandmediationservices. Theycanbereachedat [email protected] and [email protected] or204-825- 7392and204-825-8443

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