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Rebuild Your Balance Sheet to Remain Credit-Worthy

Managing razor-thin margins and maintaining positive cash flow are two critical tactical maneuvers confronting producers as the 2015 growing season draws to a close.

Heady grain prices between 2006 and 2013 catapulted many U.S. farmers into strong financial positions. 

Now, with a forecasted 36% net income drop from 2014 to $58.3 billion in 2015, they’re confronting what would be the lowest net income since 2010 (and $29.1 billion below the 10-year average). Crop receipts are expected to fall by $12.9 billion from 2014. 

The current downturn isn’t a crisis, says Michael Swanson, chief agricultural economist for Wells Fargo Corporation.

“The ratio of net farm income to gross revenues has been bumping along at 20% to 25% since the 1990s,” he says. “It sank to 16% in 2015. It’s not a problem for a year, but it gets more serious over time.” 

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The question: how will farmers remain credit-worthy in an era of rapidly declining profitability?

Balance sheets have been reinforced by a solid foundation of machinery, land, and current asset values. Farmers have increased their cash, grain inventories, and prepaid expenses, building higher working capital and more capacity to repay short-term debt.

Yet, current ratio (a measure of working capital: current assets ÷ by current liabilities) has been declining since 2013, and farmers will be siphoning stockpiled working capital to meet cash shortfalls precipitated by low incomes.

No doubt your lender will be asking you to drive down costs, renegotiate cash rent rates, and refocus on marketing as a key part of your profit-generating arsenal. 

In some cases, that may not be enough.

“Liquidity has been compared with fuel in the tank,” says Brandy Krapf, Illinois FBFM Association. “When your fuel gauge shows it’s half empty and you can’t see the bright lights of the next truck stop, you have three refueling strategies” to improve current ratios:

1. Sell noncurrent assets.

2. Restructure existing operating debt as intermediate and long-term debt.

3. Inject capital from other nonfarm business sources or from outside investors.

“What’s happening on a lot of operations is a problem of repayment capacity and profitability,” says Charles Brown, Iowa State University farm management specialist, Oskaloosa. 

“A lot of farmers have decent working capital. When times were good, debt was put on one-year operating notes, where it ties up working capital. We’re seeing machinery reamortized on a five- to seven-year payment structure, where it typically should be, to preserve working capital.

“Lenders are tightening working capital requirements, and more are saying no to high cash rent. If you can’t get working capital, you can’t operate,” Brown says.

Corn Demand, Too
Cash rents will play a major role in cost-cutting moves. If you’re a new producer or you pay above-average cash rent, you’ll have to reduce cash flow related to 2016 production costs.

Gary Schnitkey, University of Illinois economist, says cuts of $50 per acre or more will be required if input costs fail to drop. Cash rents in 2016 will likely decrease – but not enough.

“If projections hold, 2016 will be the third year in a row in which cash rents are above operator and land returns,” Schnitkey says. 

Ryan Larsen, North Dakota State University assistant professor of agribusiness and applied economics, agrees that it is possible.  

“Lenders haven’t reported a significant downturn in rent pressures because of competition among farmers for land,” he says. 

Strong land values are a key component of a solid balance sheet. Iowa farmland values, pressured by lower commodity prices and the likelihood of higher interest rates, dropped more than 11% during 2015. 

In the case study of an actual Minnesota farmer (see on page 24 of your Mid-November issue of Successful Farming), Brown did not devalue land by 10% or machinery by 20%. “It doesn’t change the profit standpoint in the case study,” he says. “It does impact the risk ratio lenders use to determine your interest rate.”

Frayne Olson, North Dakota State University crop economist and marketing specialist, and Larsen prepare an annual stress test model for North Dakota bankers each fall by analyzing the records of about 540 Farm Business Farm Management members.

They run simulated price scenarios to determine the impact of changing asset ratios, commodity prices, or yields. Then they pinpoint how much stress an operation can absorb till it raises a red flag to a lender.

Their stress-test model offers lenders a snapshot of the strength of the general ag economy. “It’s a benchmark,” Larsen says.

If low commodity prices continue and input costs don’t drop significantly, he expects more focus on cost structure in 2016. “Cost structure and revenue will dictate profit,” Larsen says. 

A waterproof equity position will be key. How will producers adjust and recapture their losses? “This is where bankers will play a critical role,” he says.

“With three to five years of lower prices and decreased asset values, farmers no longer will be able to manage their business the same way as in the past,” Olson agrees. “The impact will fall most heavily on those with the least ability to weather the storm.” 

In some cases, lenders will advise liquidation of assets, including machinery or real estate.

Swanson says farmers have made two fundamental mistakes regarding land purchases. 

1. Overestimating the importance of economies of scale. “You have to be big enough to be efficient. Beyond that, it doesn’t necessarily lower production and operating costs,” he says.

2. Not being asset disciplined. “It’s more important to choose the right ground than to simply add land to be bigger,” he says. “It increases the complexity and cost structure of your operation.”

Farmers will default on a parcel of land that’s under water, says Allen Featherstone, Kansas State University. “Amortized loans at lower interest rates pay more principal early in the loan, reducing the possibility of loans going under water,” he says. On a 15-year-loan, it amounts to 11% more in six years. 

It’s not the 1980s over again, he says, but looking at averages can lead to a sense of complacency and a failure to recognize potential issues. “The higher risks of default exist within the averages,” he says. “The average will not drive a bust, but the tails in the distribution of default risks indicate vulnerability, and the margin will drive the average. The default risk is low, as it was in 1979, but it can change quickly.” 

At the end of 2014, Featherstone says 2.3% of Kansas Farm Management farms had greater than 70% debt to assets.    

“Repayment capacity was key in the 1980s,” he says. “It fell from 152.8% to 16.3% from 1979 to 1981, due to a 65.3% increase in interest payments and a decline in the value of farm production by 15.7%. We experienced a dip from 128.8% to 90.6% in the last two years, indicating the current difficulties aren’t nearly as serious as what happened from 1979 to 1981.”

“There are some similarities between now and the 1980s,” Olson says. “However, the real economic environment today and the structure of the farm economy are different. Nobody has seen these kinds of conditions, so we can’t take lessons verbatim from the 1980s. The market perspective also is different. There were relatively low, stable grain prices, with farm program loan rates and cost of production in the same range.

“Today’s cost of production is much higher. The downside risk and potential magnitude of losses are much higher. Crop insurance has lower commodity, premium, and coverage levels. Conditions were different, and we have to see it through a different lens,” Olson says. 

Commercial banks have been hit with significant regulations since the last major ag restructuring. Lenders may turn to FmHA guarantees, but there’s no increased federal funding.

Fortunately, the scenario isn’t dire for most farmers. “Many have strong balance sheets,” Brown says. “However, they need to consider the impact of future changes in profitability.”

Efficiency Cycle
As the largest commercial U.S. lender, Wells Fargo’s Swanson sees variations among producers in their cost structure, cash flow, and working capital. He bases the following two observations on FinBin farm data from the Minnesota Center for Financial Management.

1. There are widespread gaps between high-profit and low-profit farmers in cost of production and farm performance.

2. Production cost is a competitive advantage among producers. This includes land rent, fertilizer, seed, repairs, fuel and oil, crop chemicals, and crop insurance.

“In Minnesota, the average cost of production per bushel is $4,” he says. “It’s $7 for high-cost producers. You can’t pick a price that will solve your problem of being inefficient.”

Olson agrees. “We’d have to go back to the early 2000s to see average net farm incomes return to what they are today. We’ve been lulled into spending what we wanted, especially on the crop side. We’re going back to the old days of watching every penny,” Olson says.

Greg Royle, a Central City, Nebraska, farmer agrees. “I’m trying to control costs as much as I can,” he says. “When corn was $5 or $6 and beans were in the double digits, I didn’t bat an eye at applying fungicide.With $3.60 corn and $8 beans, though, I can’t recoup the costs. I’ve scouted my fields constantly this year. In this environment, I look at every cost. With $3.60 corn, everything changes.”

To see a case study and get more information, flip to this story on page 20 of your Mid-November issue of Successful Farming

Our Mid-November issue of Successful Farming reminds us to stay focused, stay positive, and, most importantly, #StayFarming.

Join us in using #StayFarming to share marketing tips, ways to cut costs, info on rebuilding balance sheets, and more.

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