From Tina LeBrun and Wayne Schoper
South Central College
Agriculture, specifically crop agriculture, currently is on an extended positive run. Midwest land values are climbing and interest rates are at historic lows. At the same time crop inputs and output price volatility has increased. However, no one exactly knows when we'll have a downturn; but, there are a few things to pay specific attention to during the good times.
Tina LeBrun & Wayne Schoper
Well known Agricultural Economist Danny Klienfelter says that great companies in times of chaos self-impose two kinds of discomfort: the discomfort of unwavering commitment to high performance in difficult conditions, and the discomfort of holding back in good conditions. During the top of the good time cycle period, we want to avoid another farm financial disaster by setting some standards to avoid crisis like situations as witnessed in the early 80's.
To start with take a look at a combination of key financial measures. Number one is the need to evaluate profitability on an accrual adjusted basis. This doesn't require a full blown accrual accounting system or switching away from cash accounting for tax purposes. It just requires having balance sheets as of the beginning and the end of the period for which you're measuring income. So if it's a calendar year you are measuring, have a balance sheet for January 1 and December 31st. It also requires that the balance sheets are complete, meaning they include the accrual assets and liabilities such as accounts receivable, inventories on hand, prepaid expenses, investment in growing crops, accounts payable and accrued expenses.
Most Farm Business Management Instructors have financial guidelines to follow or you can go to the Farm Financial Standards Council (FFSC) website to get a copy of their recommendations. Many Ag lenders have found that cash basis income can lag accrual adjusted income by as much as 2-3 years in reflecting developing problems or on the other hand that the business has started to turn around. That's often too late to take the action that's needed.
A second thing to evaluate is if your debt is being used profitably in the business by looking at whether your ROE (rate of return on equity) is greater than your ROA (rate of return on assets). It is possible for ROA to be greater than ROE and the business to still be profitable if the business isn't too heavily leveraged, but it means that the owners are accepting a lower rate of return on their own funds in order to offset the fact that the return on borrowed funds is less than its cost. If the rate of return on borrowed funds is less than its cost, the owners' capital absorbs the shortfall and it drags the rate of return on all invested funds down
The third evaluation point is the ratio of net working capital (current assets less current liabilities) to gross revenues. This one is a little harder, because the minimum standard depends of several factors. For example, how heavily leveraged is the business, how variable are cash flows from year to year, are rents share, flex or fixed cash? The general guidelines Klienfelter suggests following are:
Share rent (or owned land)and a debt to asset ratio of less than 25 percent, then a working capital to gross revenue of at least 25 percent
Flex rent and a debt to asset ratio of less than 40 percent, then a working capital to gross revenue of at least 30 percent.
Fixed cash rent and a debt to asset ratio of less than 50 percent, then a working capital to gross revenue of at least 40 percent.
With fixed cash rents and a debt to asset ratio of over 50 percent then a working capital to gross revenue of at least 50 percent.
Keeping these financial measures in tact will allow your farm business to remain profitable not only in the good times, but also in the not so good times. Start building your business for the future before it's too late.