What's in Your War Chest

By Des Keller
Progressive Farmer Contributor

Your farm business needs to build a cushion of capital, or cash, to bolster the operation for that proverbial rainy day. But, what do you do when the rainy day lasts for three or four, or even more years?

“Net farm income is really low and has been relatively low several years running,” says Michael Langemeier, an agricultural economist at Purdue University. “Liquidity has been declining. Balance sheet debt has increased on the noncurrent side, which means farmers are borrowing more against their land.”

Borrowing against farmland isn’t necessarily a bad decision, but it “does have long-term ramifications that need to be thought about,” Langemeier says.

INCOME VS. EXPENSES

U.S. net cash farm income from 2017 to 2018 is expected to have declined 13% from 2017’s level, to $91.5 billion. Farm-sector debt, when adjusted for inflation, is expected to increase $5.6 billion. Total farm-sector debt, adjusted for inflation, topped $400 billion in 2017 and 2018. That level, in inflation-adjusted dollars, hadn’t been this high since 1984.

While commodity prices haven’t generally been good for the bottom line, some farm expenses have decreased. Cash rents are one, Langemeier explains. They are down 15 to 20% from highs several years ago. Fertilizer costs are also lower than they were a few years ago, although prices seem to be poised to rise again.

Costs that have stayed the same or increased include herbicides and seed. Costs for labor and interest rates are expected to be higher for the year, according to USDA. Interest rates have ticked up slightly, though they are still in historically low territory. However, as interest rates rise, land values tend to go down, Langemeier says.

The total cost of corn production has declined about 50 cents per bushel from the highs of 2014. “The big question,” Langemeier asks, “is where is the next 10-cent savings per bushel going to come from?”

PROACTIVE STEPS

That is certainly on the mind of growers. Rex Reyher farms 4,700 acres on the arid high plains of southeast Colorado growing corn, alfalfa, wheat, sunflowers and, in past years, sorghum. With capital already tight, he cut costs heading into the 2018 season.

“If I’d operated this year as normal, with typical expenses, I’d be in trouble,” says Reyher, 37, who resides near Las Animas with his wife and four young daughters. As it is, he’s not exactly flush. That’s because the region has been gripped by a drought that has devastated yields. Reyher only harvested 600 of the 3,000 acres he planted to corn. This despite the fact his operation is 100% irrigated. The Arkansas River, from which most irrigators here siphon their water, had little to offer this year because of a lack of snowmelt in the mountains to the west, where the river originates.

In 2018, Reyher decided to apply fertilizer with 150-bushel-per-acre corn in mind rather than trying for 175 bushels. “We changed up our starter fertilizer and planned to come back with a sidedress application,” he says. Given the lack of moisture, he opted to forgo the sidedress. “If we hadn’t gotten some rain at the end of July, we wouldn’t have a crop at all.”

Reyher saved about $45 per acre in fertilizer costs. In keeping with the planned lower rates of fertilizer, Reyher also cut back corn-plant populations from 28,000 per acre to 25,000. That decision saved another $25 per acre, or $75,000 over 3,000 acres.

Of course, those savings don’t help as much when you don’t have grain to sell. Fortunately, Reyher credits crop insurance for buoying the operation enough this year to at least break even.

He also harvested corn that didn’t mature as silage--silage he can sell.

“We had a pretty good inventory piled together last fall,” Reyher says. “We worked really hard to take a lemon and turn it into lemonade.”

TIME TO PRIORITIZE

Reyher isn’t alone. “People are in a mode to prioritize,” says Brent Gloy, an ag economist and full-time farmer in southwest Nebraska who publishes ageconomists.com, which expresses the views of Gloy and David Widmar, an economist at Purdue University. “There’s only so much money available, and you have to figure out where you want to spend it. Farmers can pay for land, or they can pay for their equipment,” he continues. “Right now, there’s really not a lot of extra money after you pay for one of those two things.”

As with Reyher, producers should try to get a return wherever they can, Gloy believes. “People have to be judicious with rents. You try to replace equipment, as necessary, but make it last longer than it used to.”

Gloy uses crop-revenue insurance for his operation along with requisite hail insurance in that part of the country. “The risk-management tools are adequate in my opinion; it’s just whether people are using them.”

BUILD YOUR CAPITAL

There are several ways to increase your farm’s working capital, Langemeier, Gloy and others agree. Admittedly, these recommendations may be easier said than done in today’s economy. They include:

> Benchmark, reduce per-unit costs and improve productivity.

There are multiple financial ratios to use to assess the health of the business. Collectively, there are more than 20 ratios, though the number considered to be vital to watch is 10 or fewer. The most commonly known is a business’s equity ratio, which measures debt against equity (capital). Another benchmark, capital debt repayment margin, is discussed in “Check Your Capital Debt Repayment Margin,” below.

> Retain a larger percentage of earnings.

Ideally, you should have at least 20 to 25% of net working capital on hand. Net working capital is calculated as current assets minus current liabilities divided by gross revenues. If your debt is higher, net working capital on hand at a level closer to 50% is even better.

> Direct more retained earnings to current assets rather than noncurrent assets.

“This point is often overlooked,” says Widmar. “How is the farm deploying profits? The temptation could be to take advantage of section 179 (accelerated depreciation) and buy equipment to reduce a potential tax liability. However, this puts profits into a noncurrent asset, which are hard to leverage during a financial slowdown. There isn’t a right or wrong way of going about this; each farm needs to look at its current financial situation and consider its future needs.”

> Work with lenders to make sure debt matches current cash-flow.

This might involve restructuring several loans into one--perhaps for a slightly longer term. This move doesn’t necessarily square with the idea of a loan term matching the useful life of an asset, but this can be insurance of sorts in the short term.

There is no silver bullet to survival, just several smart financial moves to save money and keep more of it, Langemeier says. Liquidity would be much worse today if it weren’t for generally good yields across much of agriculture.

Check Your Capital Debt Repayment Margin:

Over a five-year average, the farm’s replacement margin should be healthy enough to be able to replace equipment and grow the business, explains Michael Langemeier, a Purdue University ag economist,

“This margin should be enough to cover depreciation plus another 10 to 20%,” he says. “The margin should be of that magnitude. You can’t have that large a repayment margin every year, but over a five-year average, there has to be a 10 to 20% cushion beyond covering depreciation. Otherwise, that is a really bad signal.”

Capital debt repayment margin clearly illustrates that net farm income, net off-farm income and depreciation have to be large enough to cover owner withdrawals and principal on term debt.

How is capital debt repayment margin and replacement margin calculated? You first need to know your capital debt repayment capacity. Here’s how that capacity is calculated.

Capital Debt Repayment Capacity:

Accrual Net Farm Income

+ Off-Farm Income

- Income and Self-Employment Taxes

+ Interest Expense on Term Debt

+ Depreciation

- Family Living Expenses

= Capital Debt Repayment Capacity

You use that number as a starting point to determine your capital debt repayment margin.

Capital Debt Repayment Margin:

Capital Debt Repayment Capacity

- Interest Expense on Term Debt

- Principal on term debts and capital leases

- Unpaid operating debt from prior period

= Capital Debt Repayment Margin

Replacement Margin:

Capital Debt Repayment Margin

- Cash Used for Capital Replacement(Depreciation plus another 10 to 20%)

= Replacement Margin

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