LOMBARD AGRICULTURE WHITE PAPER: INVESTING IN THE FUTURE: ACQUIRING NEW ASSETS TO RAISE THE BOTTOM LINE

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1 LOMBARD AGRICULTURE WHITE PAPER: INVESTING IN THE FUTURE: ACQUIRING NEW ASSETS TO RAISE THE BOTTOM LINE Written by Roger Moore, food and farming consultant at Rural Renaissance lombard.co.uk

2 2 AGRICULTURE White Paper INVESTING IN THE FUTURE Investing in new machinery, equipment or vehicles is a big commitment for any farm business, where tight margins and unpredictable external forces can make investment decisions tricky. But rather than asking whether you can afford to invest, perhaps the question should be can you afford not to? New assets such as tractors, milking parlours, production equipment, slurry stores and renewable energy systems can transform the way you work, improving efficiencies and, ultimately, your bottom line. Whether you are considering investing in these new assets using cash or finance, it is important to determine the full range of options available to you. Machines and equipment are often the most valuable, regularly disposable asset for a farm business, so taking the time to find the best deal before acquiring capital pays off throughout the period they are in your possession. Thoroughly researching the value a new asset can bring to your operation is time well spent. What efficiency savings will it bring? How can you find the best deal? What will be its residual value when the time comes to replace it? How much will it cost under finance? And, crucially, is it really affordable?

3 3 AGRICULTURE White Paper THE CURRENT OUTLOOK After an unpromising start to 2014, which saw severe flooding in South West England, the growing season progressed with good weather conditions to give higher production levels on the previous year. But bumper harvests drove down prices, resulting in a 2.2% reduction in the total value of outputs. Cereals, for example, saw price falls of around a quarter, with falls continuing into this year. The total income per annual work unit (AWU) equivalent to the input of one member of full-time staff over one year fell by the same percentage to 27,847, a fraction lower than the figure for 2011, the last year we escaped the impacts of adverse weather. Meanwhile the stronger pound exerted further downward pressure on farming incomes as Single Farm Payments fell by 459 million. Add in the burdens of increased labour and rent costs, and it comes as no surprise that the UK s Total Income from Farming fell last year to 5,379 million, a 4.4% real-time drop on 2013.

4 4 AGRICULTURE White Paper THE CURRENT OUTLOOK IN 2014 FARMING S CONTRIBUTION TO THE UK ECONOMY, KNOWN AS GROSS VALUE ADDED, INCREASED BY 3.2%. Despite declining incomes, farming s contribution to the UK economy, known as Gross Value Added, actually increased by 3.2%. Viewed in the context of an anticipated fall in commodity prices for summer 2015 one thing is clear now is a challenging time for UK farm businesses! The picture for investment in new farm assets is similarly mixed. Taking registrations of new tractors as a benchmark we see that annual sales fell by less than 1% last year, while farmers opted for more powerful models. Encouraging signs lie in improving machinery and equipment closing balances, which rose by 9.6%, perhaps demonstrating increased levels of investment confidence. Year UK Total Farming Income per AWU ( ) 1 Gross Value Added at market prices ( million) 2 Agricultural tractor registrations (UK total) ,784 7,368 13,347 88, ,972 9,112 14,094 87, ,097 8,933 13, , ,144 9,594 12, , ,847 9,901 12, ,192 Sources: 1 & 2 DEFRA; 3 Agricultural Engineers Association; 4 Farm Business Survey Machinery and equipment closing balance sheet (England, per farm) 4 IN 2014, MACHINERY AND EQUIPMENT CLOSING BALANCES ROSE BY 9.6%.

5 5 AGRICULTURE White Paper ASSESS YOUR BUSINESS PERFORMANCE Before even considering the options for suitable new farm assets, you should begin by thoroughly assessing your business current performance. This five-step checklist will help: 1. Analyse machinery and equipment depreciation and the cost of repairs, fuel, equipment hire and use of contractors. 2. Compare similar businesses or industry standards as a benchmark to gauge how effectively your assets are managed. 3. Allocate annual repairs costs to individual items of machinery and equipment. This will enable you to identify any trends. 4. Consider the age and hours of machinery and how it compares with your labour force. Does this match any future changes, such as possible expansion or staff retirement? 5. Calculate your return on capital employed (ROCE). Expressed as a percentage, this is a business earnings before any interest or tax is applied, divided by the capital employed in the business (i.e. its total assets less its current liabilities). ROCE serves as a useful measure of the income your business generates from its available capital/assets. The ROCE ratio provides a more holistic view than pure profit margins because it focuses on efficient use of assets and low costs, thereby allowing an equal comparison to other farm businesses. So, for example, if a farm is generating a 5,000 profit (before interest and tax) from 100,000 of capital, it will have a ROCE of 5%. But a farm with a 10% ROCE would be more efficient because it needs half the capital to generate the same level of profit ( 5,000 of profit is squeezed from 50,000 of capital). RETURN ON CAPITAL EMPLOYED (ROCE) = EARNINGS BEFORE INTEREST OR TAX CAPITAL EMPLOYED IN THE BUSINESS.

6 6 AGRICULTURE White Paper PLAN FOR IMPROVEMENT Having a complete and up-to-date business plan will help you to assess your options for the future. It will also provide credibility for your business when looking for finance. It should contain information about your management team and staff, an operations plan, as well as production and financial forecasts. Your business plan should include a machinery and equipment replacement schedule, which will illustrate any anticipated changes to ages and hours of existing stock. You can then use this schedule to compare other potential asset structures and combine the results with the expected associated costs (ongoing repairs, fuel economies etc.) and efficiency savings to calculate the overall impact on operating costs. Planning for asset depreciation is a function of investment. Most farm businesses should calculate it at 18% per year on the reducing balance, a figure representing a target rather than the actual or eventual depreciation. This means your business would be investing on average over a five-year period. AN UP-TO-DATE BUSINESS PLAN WILL PROVIDE CREDIBILITY FOR YOUR BUSINESS WHEN LOOKING FOR FINANCE.

7 7 AGRICULTURE White Paper FIND THE BEST DEAL An effective business plan and machinery and equipment replacement schedule should allow you to begin identifying the type of new asset required. This is the time to begin studying the technical aspects of different manufacturers and models, such as the number of spool valves, multitude of gearboxes or extra horsepower. While local dealers usually offer a good starting point, it s often helpful to compare deals offered by local and national buying groups. The guarantees and extended warranties usually offered provide peace of mind and are useful for future budgeting but bear in mind, new machinery isn t always available immediately, while specialist equipment can take time to manufacture. It is worth checking classified adverts for equivalent nearly new or used items that offer further savings and indicate the actual level of depreciation. Remember that the best deals on used equipment are more likely to be identified over a longer period of time. Used machinery is often available straight away and it is usually possible for you or the manufacturer s engineers to inspect a pre-owned machine while still in operation at the seller s location. When you ve found the best deal at the right price, you can determine: How much funding is required; What security could be offered; How much income you are expecting; Your calculated ROCE, as well as profits or losses.

8 8 AGRICULTURE White Paper FUNDING THE PURCHASE Cash is king Using your business surplus monies is likely to be the cheapest source of funding and provides the maximum flexibility in the way you buy, operate and eventually sell the assets under consideration. It has always been the case that farmers investing in new assets should avoid using working capital to fund the purchase. A certain level of working capital should be maintained that takes into account the impacts of unexpected events beyond your control, such as extremes of weather. Using cash to fund a new asset may result in opportunity costs not at first expected. Finance options There are many finance options available, ranging from hire purchase to leasing, though usually only one will be the most suitable for your specific circumstances. While every farm business is unique, there are some fundamental points to consider when choosing the best finance package for your business: How important is outright ownership? Does the asset need to appear on or off your balance sheet? Do you have sufficient taxable profits to claim all the allowances available? Are interest rates likely to rise or fall? Would you like flexibility to pay off lump sums? An outright purchase may not be important if your business already owns other significant assets, such as land and buildings. A CERTAIN LEVEL OF WORKING CAPITAL SHOULD BE MAINTAINED THAT TAKES INTO ACCOUNT UNEXPECTED EVENTS BEYOND YOUR CONTROL.

9 9 AGRICULTURE White Paper FUNDING THE PURCHASE HIRE PURCHASE AGREEMENTS ARE THE MOST POPULAR FORM OF FINANCING AMONG FARM BUSINESSES, ACCOUNTING FOR AROUND 90% OF NEW MACHINERY FINANCE. Paying for new assets over time, as it generates income for your business, can be more attractive than making an advance payment in full think of it as paying wages monthly rather than years in advance. The current low cost of finance effectively means you could be making use of third party investment for little more than an arrangement fee. A common mistake is to compare a flat interest rate with the true annual cost, or Annual Percentage Rate (APR). The flat rate is calculated on the opening balance of the loan and then applied across the entire amount for the full period of the loan, while the APR is calculated on the reducing balance. But don t be too focused on the interest rate the value you are obtaining is more important. Hire purchase Hire purchase agreements are the most popular form of financing among farm businesses, accounting for around 90% of new machinery finance. The machinery is capitalised on the balance sheet and depreciated against the profit and loss account. The net cost owned by you will show value added to the business. You make the payments and at the end of the agreement you own the kit. VAT is payable up front, in full, and reclaimed when payments begin. Recent rises in machinery and equipment costs due to exchange rate fluctuations and the rising costs of raw materials have led buyers to consider alternative finance options. Keeping the asset away from the balance sheet and using it at a fixed price can actually be beneficial for some businesses.

10 10 AGRICULTURE White Paper FUNDING THE PURCHASE CONTRACT HIRE ENABLES AN IMPROVEMENT IN THE FINANCIAL GEARING OF YOUR BUSINESS BECAUSE THE ASSET DOESN T COUNT AS AN INTEREST- BEARING DEBT. Contract hire Contract hire offers a fixed monthly payment where the asset doesn t appear on your balance sheet. The residual value risk is avoided, an associated maintenance contract is usually included and at the end of the contract the machine or equipment is simply returned. Contract hire enables an improvement in the financial gearing of your business because the asset doesn t count as an interest-bearing debt. Large agri-businesses prefer to reduce the cost of liabilities this way, while still seeing an improvement on their ROCE. If you don t have sufficient taxable profits, contract hire may be more attractive because the lender will claim the capital allowances and this will be beneficial by way of lower rental charges. Finance lease A finance lease is where a rent is paid for using the asset. After the full capital cost is paid, it s often possible to continue renting the item at a far lower rate. The principal benefit of this financing structure is that all of the rental costs paid can still be offset against your business profit. Care should be taken with leases where there s an option-to-purchase fee, as these are slightly different to normal operating leases for tax purposes. Operating lease An operating lease is similar to a finance lease because you pay to use the asset. The difference is that the payments don t cover the full cost of the asset, although the benefits of offsetting against profits are the same. You are also responsible for maintenance of the asset. This type of lease is commonly used to acquire machinery or equipment on a relatively short-term basis, to be maintained by you and then returned afterwards.

11 11 AGRICULTURE White Paper ANNUAL INVESTMENT ALLOWANCE The Annual Investment Allowance (AIA) is a capital tax allowance available to businesses of any size. It offers a 100% allowance on qualifying capital expenditure in the year of purchase. The AIA is currently set at a temporary level of 500,000 until the end of This means the first 500,000 of hire purchase expenditure can be claimed against taxable profits, just as if cash had been paid, even though the actual outlay in the first year would be considerably less. In his July budget the Chancellor announced that the permanent level of AIA will be raised from its starting point of 25,000 to 200,000. While on one hand businesses may be disappointed that the temporary level of 500,000 was not made permanent, setting a constant level will allow businesses to plan their capital investment and therefore provide a level of continuity. In the meantime the 500,000 level will be in place until the end of the year so for farmers wishing to take advantage of the higher level, now is a good time to review, or potentially bring forward, any planned expenditure. Year AIA , , , , ,000 THE 500,000 AIA LEVEL WILL BE IN PLACE UNTIL THE END OF THE YEAR, SO NOW IS A GOOD TIME TO REVIEW OR BRING FORWARD ANY PLANNED EXPENDITURE. Source: UK Government

12 12 AGRICULTURE White Paper THE MOST EFFECTIVE ASSET INVESTMENTS ARE ACHIEVED IN THE PROCESS LEADING UP TO SELECTING FINANCE. CONCLUSION If your business has sufficient taxable profits to claim some or all of the AIA, it offers a powerful incentive to take up a hire purchase agreement for assets of significant value before the end of 2015, when the AIA drops. On the other hand, if your business has little or no taxable profits then contract hire or a lease agreement is likely to be the most affordable deal. Overall the most effective asset investments are achieved in the process leading up to selecting finance. Diligently completing business analysis and planning, including a machinery and equipment replacement schedule, will enable you to find the best deal and, ultimately, the right finance package for your specific farm business needs. Needless to say, it is always best practice to check your financial calculations, as well as any tax implications with your accountant, before proceeding with your preferred finance agreement. Security may be required. Product fees may apply. TO FIND OUT HOW YOU CAN BENEFIT FROM LOMBARD S SERVICE CALL TEXT RELAY LBF