Lenders, farmers and agriculture researchers are scratching their heads and wondering if we are in a “new normal.” The increasing demand for food, fiber and fuel is likely to continue as we face population growth to an estimated 9 billion people by 2050, but is this simply déjà vu? Similar to now, in the 1970s, farm and ranch land values were driven upward by the perception of a growing global marketplace and increased standards of living in developing countries.
The increasing farm real estate values experienced in the 1970s and again in recent years result in long-term debt servicing commitments. In order to prevent history from repeating itself, the focus this time needs to be on profitability and repayment capacity rather than the asset-based lending of the past.
According to reports published by the USDA, the number of very large farms (those with over $500,000 in inflation-adjusted annual sales) has grown and the large farms’ share of production has increased since the 1970s (O’Donoghue et al.). The increased size of many agricultural operations alone has resulted in larger loans and increased repayment risk. In addition, today we see an increase in the prevalence of counter-party risk (Kohl). Multi-year lease arrangements and production contracts are just two of the areas that while typically used as risk management tools, may also leave farmers and ranchers more susceptible to counter-party risks.
Profitability and Repayment Capacity
From the lending perspective, focus needs to be placed on profitability and repayment capacity of farm and ranch businesses rather than the asset-based lending prevalent in the 1970s. The Farm Financial Standards Council recommends a number of measures that should be examined and provides guidelines on their calculation to help in the reporting of uniform financial records (Financial). In order to adequately evaluate repayment capacity, accrual-adjusted income statement data must be available. Accrual-adjusted income statements are more accurate when examining business performance because income is recognized when it is earned and expenses when they are incurred. However, cash basis accounting is often used by farmers and ranchers because it is generally easier and allows for more flexibility in tax planning.
Accrual-Adjusted Income Statement
A spreadsheet has been developed at Purdue University that allows users to cost-effectively analyze the financial condition and performance of an individual farm or ranch business following the guidelines provided by the Farm Financial Standards Council (Miller et al.). Users of the spreadsheet are able to automatically prepare an accrual-adjusted income statement after entering data from their beginning and end of tax reporting period balance sheets, Schedule F of the federal income tax return, and, if applicable, the Form 4797 of the income tax return. The spreadsheet consists of a set of five worksheets that provide a simple, step-by-step procedure for entering data and is available at no-charge at www.agecon.purdue.edu/files/EC712.xlsx.
Another feature of the spreadsheet is the ability of users to examine their profitability, liquidity, solvency and financial efficiency measures (Barnard et al.). The measures recommended by the Farm Financial Standards Council are automatically calculated and reported and users are able to enter industry benchmarks or averages to compare their individual farm or ranch business to the industry average. The strengths and weaknesses for the business are then highlighted on the spreadsheet. Measures are identified as neutral if the results fall within a range from 10 percent lower to 10 percent higher than the benchmark. If weaknesses are identified relative to industry averages, users can begin to identify courses of action to address these areas.
Five repayment capacity measures can also be calculated in the spreadsheet with additional information provided by the user: capital debt repayment capacity, capital debt repayment margin, the term debt and capital lease coverage ratio, replacement margin and the replacement margin coverage ratio. After the replacement margin has been calculated, participants can estimate the amount of additional debt that could be serviced by that margin. The user is able to specify a percentage of the margin to hold in reserve to provide a margin of safety against the possibility of future declines in gross income and thus determine the amount of additional debt the business could safely service (Barnard et al.).
Profitability Linkage Model
The DuPont Financial Analysis System, which is also known as the profitability linkage model, is a financial analysis system that can link production, marketing and financing decisions to financial performance through financial ratios (Barnard et al.). Various production, marketing and financing alternatives can be identified using the financial ratios calculated and comparative data for the industry. Likely causes and possible alternatives for addressing business weaknesses can then be identified.
This system is embedded into the available spreadsheet and enables the user to evaluate the impact on the return to equity of each of three alternatives being considered for improving financial performance. The numbers used in this calculation are transferred from the previous worksheets in the spreadsheet; however, the costs do need to be separated into fixed and variable classes.
While we certainly hope agriculture will not experience a major downturn in the near future, focusing on the repayment capacity of farm businesses is an important tool in the evaluation of the amount of additional term debt that can be taken on by the user and avoiding the mistakes of the 1970s. The volatility in agriculture yields, commodity prices and input prices can all increase repayment risk. Major events such as the drought in the Midwest during the summer of 2012 significantly increased repayment risk for some producers due to the drop in net incomes of those affected farms. The spreadsheet provided by Purdue University provides a free tool for preparing the necessary accrual-adjusted income statement and allows the user to calculate five repayment capacity measures for their business.
Freddie Barnard and Elizabeth Yeager are professor and assistant professor, respectively, in the Department of Agricultural Economics at Purdue University. They can be contacted at barnardf(at)purdue.edu or eayeager(at)purdue.edu.
Copyright (c) June 2013 by BankNews Media
Barnard, F.L., E.A. Yeager and A. Miller, (2012 forthcoming). “New Features Added to the Purdue Farm Financial Analysis Spreadsheet.‚ Journal of the American Society of Farm Managers and Rural Appraisers.
Financial Guidelines for Agricultural Producers: Recommendations of the Farm Financial Council (Revised). (January 2008).
Kohl, D.M. (2012). “Comparing and Contrasting 1970-1980 and 2010-2020: DäjŸ vu?‚ FarmerMac. Dave’s GPS.
Miller, A., C. Dobbins, M. Boehlje, F. Barnard and N. Olynk, (July 2012). Farm Business Management for the 21st Century: Measuring and Analyzing Farm Financial Performance. Department of Agricultural Economics, Purdue University Cooperative Extension Service EC-712.
O’Donoghue, E., J. MacDonald, U. Vasavada and P. Sullivan, (2011). “Changing Farming Practices Accompany Major Shifts on Farm Structure.‚ USDA ERS. Available at www.ers.usda.gov/amber-waves/2011-december/changing-farming-practices.aspx.