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Financial
cash flow analysis
Farm forestry financial analysis can be thought
of as incorporating The good,
the bad and the ugly:
The Good are
the returns from timber and agricultural products and services
generated by the project. Some of these are easy to estimate
and value, while others present real challenges and are best
left out of the analysis. It is difficult to put a realistic
dollar value for example on the satisfaction farmers get from
improving their property or being able to pass on a better farm
to their children. Individuals will instinctively know how important
these benefits are and should consider them when making their
final decision.
The Bad
are the costs the project incurs. Most of the financial costs,
including labour, are incurred in the early years of the project
so they are generally the easiest values to incorporate into
the analysis. A farmer can quickly estimate the costs of buying
seedlings or preparing the site for planting.
The project cash flow
Once the costs and returns have been estimated,
the project's cash flow can be calculated. This is relatively
simple using a spreadsheet. Any year’s anticipated costs
and returns can be incorporated and summed to provide a total
cost and a total return each year. The net cash flow is yearly
returns minus yearly costs.
Once the project’s cash flow has been calculated it is
possible to calculate future financial commitments over the
life of the trees. This can be done by considering when payments
are due and returns expected. Those whose main interest is the
final figure or bottom line often overlook the project’s
cash flow. Unfortunately many forestry investments require a
high up-front investment and a long wait for returns.
The Ugly are the problems
associated with time and the effect it has on future costs and
returns for a long-term investment like forestry.
Most investors know that today’s dollar is worth more because
of its investment and income-generating potential than a dollar
in the future. But this is complicated by the fact that the
longer the investment, the more uncertain the risks and rewards
become. The discounted cash flow analysis tool is designed to
help with many of these issues and provide a framework for thinking
about, and resolving, these issues.
Accounting for long-term investment periods
Discounted cash flow analysis is a process
that uses financial discounting to compare costs and returns
over a long investment period. It is an economic tool to deal
with time. It is interesting to note that discounted cash flow
analysis was developed in 1849 by a German forester, Martin
Faustmann, as a tool to economically evaluate forestry projects.
To judge a project’s viability, the costs and returns incurred
in different years are discounted to a present day value so
they can be adequately compared.
It is impossible to know if a farm forestry
project is a good investment unless it can be compared to other
investment options—for example, putting money in the bank,
the share market, buying a new tractor or continuing to farm
in the same way as before. Most farm forestry analyses benchmark
a farm forestry project against current land use: Is farm forestry
more profitable than the agriculture I am currently doing? To
answer this question, farmers must know what their land is currently
earning so that it can be compared with probable farm forestry
earnings. This may seem simple, but because agricultural incomes
rise and fall, farmers should be cautious about specifying a
figure. It is important to think about how costs and returns
have fluctuated over the years and how they might change in
the future. After thinking about these issues, a potential farm
forester can nominate an average figure to use when comparing
conventional agriculture with a farm forestry project.
How to estimate
the returns
How to
estimate the costs
How to
do a discounted cash flow analysis
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