How do you know if you are over equipped or under equipped? In other words, do you have the right number of tractors, combines and seeders on your farm? When do you need to buy or change equipment? What if you decide to seed more acres and one combine isn’t quite enough but you don’t need two. What do you do then?
These are common questions that many producers ask, and as with most farm management decisions, there’s no clearcut answer, but there are a number of ways to look at it and different benchmarks that farmers can apply.
But before he even starts trying to give producers some of those tools, Joerg Zimmermann makes it clear that although every equipment decision is different for every farm because they all have unique situations, those decisions should always be made with a clear understanding of how they will impact the entire operation both financially and organizationally.
“Equipment decisions are heavily dependent on the farm situation and the area where the farm is located,” says Zimmermann of GlobalAgAdvisors Ltd. “If we based everything on the 2016 harvest, a 5,000-acre farm would probably need 15 combines because the harvest was in such a small window.”
That’s obviously an extreme example, but the point is that there are many different factors — some more realistic than others — that go into an equipment decision.
“It’s not always possible to seed 24-hours-a-day or find extra workers, and the harvest window is often tight, but these circumstances can often be used as an excuse to justify a new piece of equipment,” says Zimmermann. “We can give some idea of benchmarks to follow, but equipment decisions are still highly dependent on each farm’s situation, even if looked at from an objective point of view.”
Equipment is “lumpy”
Zimmermann and Larry Martin of Agri-Food Management Excellence recently offered a series of workshops in Guelph, Winnipeg, Regina, Saskatoon and Red Deer for Canadian farmers about developing a farm equipment management plan.
The problem, says Zimmermann, is that equipment is “lumpy.” “What I mean by lumpy is that you can’t buy 1.35 combines, so you always need to have the higher number and with two combines you are over mechanized,” he says. “Then what happens is you maybe take on a few more acres and find out that you need an extra seeder, but you run into the same problem; you need 1.2 seeders, but you will have to buy two and it continues on.”
Zimmermann and Martin recently completed a study with BDO that compared what the most profitable farms do compared to the least profitable in terms of equipment management. The preliminary findings suggest that for the most profitable farms, deprecation of equipment is between eight to 10 per cent of the revenue.
Time value of money
Although farmers often have a good handle on what technology they want their equipment to have, such as horsepower, GPS, seeding row width, precision seed placement, variable rate application, etc., they also need to consider financial and business parameters. Through their workshop, Zimmermann and Martin are introducing some of those parameters, including net present value, impact on working capital, debt service capacity and the balance sheet and tax considerations with the goal of helping producers better understand the financial implications of equipment decisions. “I make the analogy of the temperature gauge in the tractor,” says Zimmermann. “When the temperature gauge goes to red, what do producers do? They stop and look for the reason and that’s exactly what they should do. But wouldn’t it be useful to also have a gauge for their financial indicators like working capital?”
A concept that people sometimes have difficulty understanding is the time value of money. The basic premise is that money is worth less in the future than it is today.
“$100,000 in 10 years is worth less than it is today; how much it’s worth less, that’s another question, but it’s for sure worth less,” says Zimmermann. “I’d rather have $100,000 today than $100,000 in 10 years.”
If a producer decides to invest in a certain brand of higher cost equipment because he or she thinks it will have a better resale value in 10 years time, that’s a valid reason, because some top-tier brands do have better resale value than others. The problem is the $100,000 the farmer might get for that equipment in 10 years may only be worth $50,000 in today’s money. “The farmer might pay $150,000 extra for that tier one piece of equipment, so he will have overspent by $100,000 for it,” says Zimmermann.
What Zimmermann is trying to do is take the emotion out of the equipment-buying decision and give farmers another set of decision-making criteria. “Once you understand that today I’m paying $100,000 more for a piece of equipment, you can figure out how much higher does the resale value have to be in 10 years so I don’t lose money?” he says. “It’s quite simple to set up a spreadsheet for scenarios like this and play around with different numbers to check how much the answer changes when you change different variables.”
Net present value
The net present value concept is an extension of the time value of money concept, which basically discounts all future cash to today’s value and then subtracts the sum of those from the initial investment made.
Zimmermann guides producers through the process of setting up a spreadsheet to calculate net present value. “It’s an easy process once you see it within a spreadsheet,” he says. From there they can plug in different discount rates to find out what the best investment threshold is.
It’s often easiest to see the effect of net present value when it’s calculated on technology differences in equipment. In another of Zimmermann’s scenarios, a farm has a choice of keeping an old air seeder, buying a new air seeder with the same features as the old one, or purchasing a new air seeder with a precision seeding option that can save one pound of canola seed per acre. “On a 15,000-acre farm with 5,000 acres of canola, saving one lb./ac. of seed at $12/lb. is $60,000 a year with that new piece of equipment,” says Zimmerman. “If the precision canola seeder costs an extra $50,000 and we calculate the future cash flow with the savings, we may see that the net present value is way better than the other two alternatives.”
A similar principle can be used to determine the profitability of all kinds of investments such as land purchases, tile drainage or an investment into a workshop assuming savings over third party repair services.
Beware the small print
One thing that farmers need to be cautious of is trigger points — things like zero per cent financing — which are used as triggers for consumers to make purchasing decisions. While zero per cent financing may look like an attractive option, it’s important to do the calculations using spreadsheets, either your own or the ones Zimmermann provides, check the fine print and find out what the equipment is really going to cost compared to a cash sale.
“You have to be careful with some of these equipment deals because dealers are basically providing two products,” says Zimmermann. “One product is the equipment itself and the other product is the financing part of it, and it’s important to run the numbers so you can make a case-by-case decision.”
These trigger points can also be a temptation for leased equipment. For example, the dealer may offer a new piece of equipment without changing the payments on the lease.
“The farmer might think, great, I can get a new piece of equipment and still pay the same,” says Zimmermann. “But they need to think further ahead. So far, we still have a good commodity situation in Canada because we have a favourable exchange rate to the U.S. dollar, but what happens if we go back to a par dollar? We would probably be happy if we didn’t have a whole lot of debt on our books. In the lease example, maybe the goal isn’t to keep our debt and lease service the same, maybe it’s to lower it for times that are not so good and build up some working capital.”
Typically, a new piece of equipment loses a large share of its economic value in the first few years of use, but, says Zimmermann, depreciation is not a cash expense. “You don’t have to pay it off your bank account, it is a cost and it’s counted in your income statement, but you don’t get an invoice for it,” he says. “A farmer might say, ‘I need to change this combine because I think my motor is going to blow up in two years and that’s going to be a $50,000 invoice.’ That’s true, older pieces of equipment probably break down earlier than newer ones, however, there’s a probability connected to it, whereas it’s a certainty that a farmer will have to make payments on a new piece of equipment. The farmer may never have to change that engine, and it’s cash flowed out two or five years ahead, so the time value of money is a factor and there are no additional costs with it.”
There are many good rent-versus-lease calculators available online that farmers can use to determine whether it’s better to rent or lease equipment for their operations.
“With these simple tools famers can see what impact a lease, purchase, or rent scenario has on income and expense, cash flow, the balance sheet, taxes, and working capital,” says Zimmermann. “Everybody knows you don’t need as much working capital to lease because you don’t have the upfront down payment so they can see how that affects cash flow and the balance sheet.”
What’s the long-term goal?
Some farmers will also purchase equipment at the end of the year as a tax saving measure, but again, says Zimmermann, it’s important to know how effective that strategy really is from a long-term standpoint.
“If a farmer buys a $400,000 sprayer, which truly saves about $6,000 in taxes, on the other side of it he or she has $30,000 more in debt service or cash flow requirement for the years to follow,” says Zimmermann. “There is nothing wrong with saving taxes, but that should not be the driver to buy a piece of equipment. You buy that piece of equipment because you need it and if you save some taxes that’s great, but you’re buying this savings in taxes with future debt service which is usually way more than the tax savings, so it’s a cash flow issue.”
“A great example was one person attending our workshop who told us he didn’t look closely enough at the lease contract and found out the lease only allowed for 500 hours of operation, which he blew through in the first two years,” says Zimmermann. “His lease contract was for four years so he had two options. He could either continue to use the tractor and pay $210/hour for the additional hours of use, or he could just leave the tractor in the shed for the next two years, still pay the payments and get another tractor to do the work.”
The best plans are constantly changing, but the power of having an equipment management plan is that producers can at least see what impact their equipment decisions potentially have on their financial. “Things don’t always go as planned, but at least they understand where they are, and can just make better prepared and even quicker decisions,” says Zimmermann.