The scissor effect: why growing farms run into cash-flow strain

The scissor effect: what are we talking about?

If you have invested to grow your farm but your cash position keeps getting tighter, your income is seasonal on top of that, and yet your accounts show better technical results and higher value added, you may well be — without knowing it — in the middle of a scissor effect!

In business economics, the "scissor effect" describes a situation in which two variables move in opposite directions (one rising, the other falling). Plotted on a graph, the two curves look like a pair of open scissors — hence the name. France's social security system, for example, faces a scissor effect: on one side the revenue that funds it falls (high unemployment), on the other longer life expectancy and medical progress push spending up.

The scissor effect is one of the things to watch in a financial diagnosis, particularly on any farm in a growth phase. It measures the opposite movements of costs and income and helps explain changes in profit: at first, income may exceed costs, but the two move in opposite directions — income falls while costs rise. Once the curves cross, costs exceed income, which often results in a loss.

The scissor effect isn't always the result of poor management of costs and income. It can have several causes, such as seasonal production with income concentrated at certain times of year but regular costs (arable farmers, suckler beef farmers or market gardeners, for example), or products whose selling prices are low because of a globalised market while costs are not falling (overproduction pushing prices down, embargoes or disease in producing or major consuming countries, political decisions…).

From an economic point of view, this crossing is abnormal, since income and costs should normally move in proportion. Higher turnover means more spending on raw materials and goods, more staff costs and so on — and the reverse when activity slows. But that is the theory, and the theory doesn't always apply.

In some cases, costs can be high at the start and then gradually fall while income rises, which again forms a scissor shape. This is typically the case when setting up or changing the farming system (installing robots, changing feeding, converting to organic…). At first, costs are high, partly because the production process isn't yet fully mastered. Income may therefore be lower at the start and costs higher, because they are less well controlled.

A major investment phase is another classic trigger: the farm makes large investments that weigh heavily on results because of higher depreciation, loan interest (fixed assets are usually financed with bank loans) and staff costs (when the investments don't replace existing ones), among other things.

The scissor effect on a growing farm

The scissor effect can also hit any fast-growing farm. To understand the mechanisms behind it, it helps to recall a few accounting concepts, in particular working capital requirement and EBITDA.

Working capital requirement (BFR)

Working capital requirement (besoin en fonds de roulement – BFR) is the time lag between the cash paid out to produce and the cash received from selling the product or service.

Cash management then becomes a priority for the business, which must anticipate this lag so as not to end up unable to pay its debts as they fall due.

EBITDA (EBE)

EBITDA (excédent brut d'exploitation – EBE) is the business's economic result before taking into account its financing policy (financial income and costs are excluded), its depreciation (which involves no cash outflow) and its tax rules.

EBITDA therefore represents the potential cash flow generated by operations.

Operating cash flow (ETE)

Operating cash surplus (excédent de trésorerie d'exploitation – ETE) is the actual cash flow generated by operations.

The difference between EBITDA and operating cash flow comes from the working capital requirement. EBITDA is "just" a subtraction (operating output – operating costs – staff costs) that ignores the cash lag between producing goods and selling them.

That is why operating cash flow is calculated as follows: ETE = EBITDA – change in working capital requirement.

What is the impact on the farm?

When a farm is growing fast, turnover rises. That increase raises EBITDA, but also the working capital requirement (more raw materials bought, stock built up…).

If the working capital requirement grows faster than EBITDA, the scissor effect bites once reserves run out. Operating cash flow turns negative, depriving the business of the financial resources it needs to keep running properly.

Running the farm then becomes tricky when the scissor effect pushes cash into the red. If the situation is badly managed or not anticipated, a series of problems can follow and feed a downward spiral:

• higher financial costs,

• difficulty paying suppliers,

• supply problems caused by late payments,

• etc.

When the scissor effect is severe, it can lead to difficulties as serious as being unable to pay debts as they fall due. If the financial disruption spreads, costs will have to be cut, which can in turn affect activity and, eventually, cash…

Farms should not underestimate the scissor effect, especially when they are growing. Paradoxically, it is precisely this growth phase that can leave the business struggling with cash management and facing a risk of insolvency. Anticipating the phenomenon properly, however, makes it possible to keep cash healthy.

How can you counter the scissor effect?

Identify the source of the cash problems

If you have cash problems, don't stay on your own! The first step is to get together with your business advisers (accountant, banker, independent adviser) and analyse the situation together, to identify clearly what is causing the cash strain. Is it cyclical? Structural? A problem with technical results? Perhaps it has nothing to do with a scissor effect at all! Either way, don't wait until your back is against the wall: the earlier the problem is tackled, the easier the solutions are to put in place and the faster they work.

Measure the cash requirement

The first thing to do is measure the scale of the problem created by the scissor effect, both its intensity (how much cash is missing) and its duration. Ideally, draw up a precise and realistic cash-flow plan (which is often harder than it sounds). This plan will help you:

• get a precise picture of the financial situation and of the time needed to restore it,

• gauge the nature and scale of the measures to take,

• prepare figures to support future discussions about the situation (partners, staff, bankers, other stakeholders…)

Note that the scissor effect is predictable and measurable: a cash-flow plan can genuinely help the business avoid being caught out by it.

Keep your lenders informed

Your bank manages a risk, and nothing is more unwelcome for it than being presented with a fait accompli. To keep a good relationship and obtain facilities on good terms, inform your bank as early as possible. The information you give should be clear, precise and reassuring. The scissor effect is a common, well-known phenomenon that banks can understand when it is explained. It is therefore important to review regularly with your banker that your short-term facilities (authorised overdraft or credit line, short-term advances or others) match your needs, especially if those needs have changed since your last meeting. Any development project should have the necessary bank support agreed upfront.

Without saying too much and boxing yourself in, it is important to give some indication — even steps or targets — of how you intend to turn the situation around.

Banks apply their own internal guidelines on short-term financing for each type of production. If the support you receive looks clearly out of line with your production capacity, raise it with your bank — and, if needed, with an independent broker.

Control spending

When cash is tight because of a scissor effect, controlling spending is essential. Ideally, start by reviewing your spending and sorting it into essential, necessary, useful and unnecessary. This will help you put certain projects on hold or drop them.

Next, it can be worth meeting your suppliers to renegotiate contract terms (prices, deliveries, payment terms, instalments…). Start with the largest ones, of course — once again, cash difficulties caused by a scissor effect are easier to explain than those caused by a downturn in activity.

You can also look at the other items that weigh on working capital, such as stock levels. Higher volumes often create room for manoeuvre that didn't exist before.

Shorten payment times to ease the scissor effect

Cash strain is most often caused by payment times. As the farm grows, this item often becomes very costly. Agricultural contractors (ETA) are the most affected. To get paid, you can agree with your customer to set up a direct debit on one or more dates fixed in advance. Be rigorous in setting up and following up your invoicing.

When cash is tight and the business is growing, it can make sense to focus on the customers who accept the terms most favourable to the business:

• short payment times (deposits…),

• the highest margins,

• the lowest costs (transport, storage…),

• the most strategic (accommodating suppliers, additional sales…)

Phase your investments

Growing the farm can itself be one of the causes of a scissor effect. Thinking about the investments and works needed over the next 10 or even 15 years is far from absurd. By looking far ahead, you won't be caught out by costly works that have become unavoidable because they weren't anticipated. It will also let you prepare your investment phases upfront by building up your cash beforehand.

This is investing in stages: after a first development phase, you pause investment for a while, to stabilise and rebuild your cash, and even strengthen it, so that you are ready for the second phase.

Postponing an investment by a year or two when cash is tight is not time wasted: the peace of mind you gain and your future ability to cope with the unexpected will only improve — and over the long term!

To conclude, it isn't always easy for a farmer to identify where cash strain comes from. Above all, it is hard to find the right solutions without identifying the right problem. The scissor effect can affect any type of farm, and cash difficulties don't always mean poor results or poor management. Because it is their job and not yours, sharing the situation with your various business advisers and keeping in regular contact with them is essential to prevent this kind of situation or get through it more calmly.

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Sources:

This article is largely based on the very comprehensive one on the Valoxy blog, with a few additions (sources in French).

https://blog.valoxy.org/effet-ciseau/

http://definition.actufinance.fr/effet-ciseau-794/

http://gecofi.fr/leffet-ciseau/