The financial tools a farmer can use to analyze, plan, and control his business include financial statements, profit and loss statements, and cash-flow statements. A financial statement tells the amount of money invested in farm assets, outstanding debts, the owner’s equity in the business, and the degree to which the farm is liquid and solvent. Liquidity is the ability to meet financial obligations on time, whereas solvency is the ability to pay all debts if the business is forced to discontinue. A profit and loss statement shows sources and amounts of income and operating expenses. Comparison of profit and loss statements over a period of years tells which resources have been most profitable and whether there has been an advance or decline in net income. A cash-flow statement shows the sources and uses of funds at given periods during the year. Such a statement provides a useful check on the accuracy of the farm’s other business records.

For the traditional farmer, land and labour (his own and that of his family) are the major resources. Under favourable conditions, the farmer has changed his role from labourer to operator-manager; much larger farm units with high capital investments have resulted. Such conditions include the existence of a considerable body of applicable scientific knowledge, an opportunity for greater efficiency from large-scale operations, the existence of good markets and transportation, the opportunity to routinize and centrally direct farm work, and an absence of community antagonism to large-scale agriculture.

The trend to the substitution of capital for labour is especially noticeable in the United States, for example, where capital accounts for a steadily increasing proportion of farm inputs. In the United States in 1940, capital comprised 29 percent of farm inputs, labour 54 percent, and land 17 percent; by 1976 capital accounted for 62 percent of farm inputs, labour 16 percent, and land 22 percent. Capital typically replaces labour when large machines do the work of several men using smaller implements; when chemicals replace the scythe and hoe for weed control; when milking parlours, pipelines, and bulk tanks replace handmilking operations; when a mechanized installation replaces the fork and bushel basket in dairy, beef, or hog feeding; when automated sprinklers bring irrigation water to crops; when cisterns and lagoons handle animal waste; when combines and forced-air crop drying speed the harvesting of small grain; and in similar substitutions.

The technical knowledge that a modern large-scale farm manager must possess is frequently held to be far greater than that required of most businessmen with equal investment; the capital required to operate such a farm is beyond the reach of many. In consequence, financial-management techniques resembling those of industry are often employed. Capital is imported from the outside; production is scheduled to meet quantity, grade, and timing requirements; and labour is given specific tasks, as in a factory.

Recognizing the economic benefits of large-scale agriculture, many underdeveloped countries have attempted to create conditions for its existence. National governments, often with outside help, have financed large-scale development programs, involving irrigation or improvement of huge acreages by means of dams, drainage facilities, and canals, and these have revolutionized the lives of many traditional farm managers within the space of a few years. Improvements in crops and livestock, marketing techniques and organization, and transport and power have in some cases increased agricultural productivity and income several times over. Since capital and management have been in the hands of government, the traditional farm manager has, however, often lost some of his independence, and not all such programs have succeeded. Poor planning and management by government authorities and resistance from the farmers themselves have led to some expensive failures.

Reducing market risks

The marketplace for agricultural commodities is exceptionally risky for three important reasons. First, no single farm producer can place or withhold enough of a single item on the market to affect the market price; second, the quantity of a commodity taken off the market does not increase in proportion to price declines; third, the farm manager cannot respond to falling prices by quickly switching production from an unprofitable item to a profitable one. To reduce his risks and safeguard profits, the farm manager may specialize or diversify depending on conditions; he may also use the futures market (see below).

A specialized farm manager concentrates his effort on the production of one item such as wheat, cotton, milk, eggs, or fruit. By such specialization he can realize the benefits of large-scale production and can make the most money from an enterprise in which he is highly skilled. On the other hand, the specialist is vulnerable to sudden changes in the market, to plant and animal diseases, and to soil exhaustion resulting from cultivation of a single crop.

Diversification—the spreading of one’s talents over more than one farming enterprise—may be accomplished horizontally or vertically. Horizontal diversification means the production of more than one item for sale. In vertical diversification, the farm manager handles raw products after harvest by processing, packaging, transporting, or even selling at retail. A poultry farmer who produces eggs and washes, candles, grades, packages, and markets them at retail is said to be vertically diversified. He has taken on some of the jobs that could have been performed elsewhere, and as a result he generally receives a better return for his efforts.

Programs of agricultural diversification have been carried out by some developing countries, with the government acting as a kind of national farm manager. Upon achieving independence, nations such as Ghana and Nigeria, in West Africa, found their economies highly dependent upon a single raw agricultural export (cocoa for Ghana; palm oil for Nigeria). Sharply falling prices for these commodities or epidemics of plant disease were seen to have disastrous effect on national prosperity. Erosion problems also caused concern. The governments responded by horizontally diversifying into other profitable crops and vertically diversifying in the establishment of industries to process these commodities or turn them into manufactured goods before export.

A capable farm manager may use the futures market to try to minimize his risks. In the futures market, the farm manager contracts with a buyer to deliver a given quantity of some commodity at a specified date in the future for an agreed price. The buyer is often a speculator who hopes that prices will rise, enabling him to sell the commodity or the contract at a profit. Futures markets enable the farm manager to establish in advance a price for a crop or earn payment for holding a crop in storage. Futures markets also permit some farmers to speculate on a price increase without storing a crop, establish in advance the price of livestock feed intended for later use, and establish an advance price for livestock.