Ultimately, we all want our business portfolio to have as little risk as possible. But can diversification be used to cut down on variability in a portfolio, and how does it work exactly? On today’s episode of Food For Mzansi TV we chat to MC Loock, the senior manager of agribusiness at Standard Bank, about the idea of using diversification as a risk management strategy.
Return on assets
Let’s start at the beginning: return on assets (ROA). Your ROA will give you some indication of how profitable your farm or agribusiness is when compared to its resources. It’s calculated by dividing your business’s net income by the value of total assets used to generate that income and giving you a percentage. If you want to determine your farm’s risk factor, you will start with your ROA.
But does risk increase or decrease from season to season?
Ideally, you either want the ROA to grow over time while the risk remains constant, or to reduce the risk over time without a decline in the ROA. By diversifying, you can have more than one revenue stream, protecting you from a decline in any one stream.
But why should you care? That’s simple: having more than one stream of income means that the risk on the ROA of your total portfolio will be lower than the ROA of any individual income stream that makes up your portfolio. (Tune into this episode of Food For Mzansi TV for Loock’s explanation of what you can do to achieve this).
Can diversification be taken too far?
Although a diversification strategy is an important tool to manage risk in your business, it can have drawbacks if improperly implemented:
- A limitation in management: Agribusiness is highly seasonal, and the management intense periods of enterprises frequently overlap. Running income streams with overlapping seasonal peaks can put strain on your management capacity
- Geographical diversification: When various businesses are situated too far apart from one another it means that tractors and equipment cannot be shared, and cost structures are often duplicated.
- Complexity of the business model: This can result in a conflicting strategy direction that becomes too difficult to manage effectively. For example, how do you allocate cost and revenues when you own adjacent links in the value chain, like the vineyard, the cellar as well as the bottling plant?