Finance Costs

There is inevitably a cost in acquiring finance for the farm business.

Even if money for investment is readily available from the business itself, the 'cost' may be seen as the lost opportunity from investing that money elsewhere where it may return a better income, so even investing money available from within the business needs to be justified.

Sources of finance

At a very basic day-to-day level, most businesses make use of merchants' credit, where payment for goods and services can be made up to several weeks later. This is a simple means of helping with cash flow in the very short term.

Peaks and troughs in cash flow can be controlled by short-term borrowing such as an overdraft. This flexibility can be expensive if not used properly and has a degree of insecurity, as a bank may remove the facility at short notice or increase charges or interest rates.

Larger projects such as capital investments can be funded by medium-term borrowing such as bank loans. This again requires careful planning but may be cheaper and easier to budget as fixed repayments are arranged in advance and a longer period exists before full repayment is made.

Long-term loans and mortgages are required for large purchases particularly when purchasing property or financing large projects, where a return is not expected for a number of years.

When acquiring finance it is essential to shop around to seek the best deal with the most favourable terms.

Payback time

This is a simple means of calculating how long an investment will take to pay for itself, calculated by comparing the cost of the investment with the extra return it will provide, but not the profit an investment will produce.

For example, an investment in machinery costing £20,000 that brings in extra revenue of £5,000 per year will have a payback time of 4 years.

Shorter payback times are preferable, indicating the reduced risk from the investment. However, payback as a means of judging the viability of an investment has its limitations, and the calculation cannot take into account other factors such as the time value of money - how soon an investment will begin to generate extra cash flow -  or financing issues.

Return on investment

A more complex means of determining the potential viability of an investment it to test it using the Return on Investment (ROI) formula. This indicates what percentage of return will be given over a specified time.

ROI is determined by taking the total investment amount, working out the increased income it is estimated to generate each year and the net profit from that, then calculating that as a percentage of the investment.

For example, a farmer wants to make an investment costing £200,000, estimating that it will generate £400,000 in income and £40,000 in net profit each year:

 

Period (years)

Estimated additional profit in period (£)

Return on Investment calculation

(£net profit ÷ £investment × 100)

  ROI   (%)

1 yr

40,000

40,000 ÷ 200,000 × 100

20

3 yrs

120,000

120,000 ÷ 200,000 × 100

60

5 yrs

200,000

200,000 ÷ 200,000 × 100

100

 

It is possible using this method to test the Return on Investment from a project using a number of different income figures, which may help to compensate for unforeseen future reductions in income for a variety of reasons, giving an indication of the margin of safety before an investment becomes difficult to justify in terms of risk.