Farmers’ Debt-to-Asset Ratio Is Deceiving, Economist Says
As farm incomes have fallen, the financial difficulty hasn’t been confined to just a few commodity groups, rather, almost all segments of agriculture are going through some tough times.
This week, we take a look at how those challenges have impacted the financial condition and performance of the farm sector.
For this analysis we again rely on farm sector financial ratios. As we discussed, these ratios are not representative of an average farm. Instead, they provide information on the financial health of the entire sector.
One measure of sector cash flow is real (2009 dollars) earnings before interest, taxes, and depreciation. Although this often is used as a measure of cash flow it’s important to remember that interest and taxes are actual cash expenses and must be paid. In other words, capital consumption is really the only noncash expense that can be delayed for any significant amount of time.
This measure shows that cash flow generation remains above the levels seen before the 2000s, but well off from recent highs. Forecast at $122 billion, the 2016 earnings before interest, taxes, and capital consumption are slightly above the average of the 1960-2016 period, which is $120 billion.
In general, this measure points to a slightly more positive picture of the farm economy than when looking at net farm income only.
Considering the decline in incomes, it appears cash flow is rather strong, but it’s important to compare cash flow relative to debt obligations.
There are a variety of measures that can be used to examine the indebtedness of the farm sector. Perhaps the most common measure is the ratio of debt to assets. This shows the proportion of sector assets that are financed with debt.
At present, debt is 13.2% of assets. This value is rather low relative to the history since 1960. This means that debts are a smaller proportion of assets than seen at many other times.
In fact, the current debt-to-asset ratio is in the bottom quartile (25%) of the observations shown (indicated by green line). In other words, at the sector level, debt is currently not all that high relative to assets. However, one should keep in mind that asset values can fall with market conditions, while debt generally doesn’t. As asset values (particularly farmland) adjust, it will be important to keep an eye on debt levels.
What About Debt Service?
As one of my wise advisers was quick to point out, the amount of debt relative to assets doesn’t matter nearly as much as the amount of debt service relative to income. One measure of debt relative to income generation is the times interest earned ratio. This ratio measures net farm income plus interest expenses relative to interest expenses.
For instance, a value of 5 would indicate that at the sector level, net income plus interest expense is 5 times greater than interest expenses. So, larger values indicate a more comfortable financial situation.
This ratio gives a very different picture of the indebtedness of the farm sector. Currently, the times interest earned ratio sits slightly below 4 times, meaning net income plus interest expenses are 4 times interest expense. Just like the debt-to-asset ratio, this value falls in the lowest quartile of the data.
Unlike the debt-to-asset ratio, being in the bottom quartile on the times interest earned ratio indicates a tighter or more uncomfortable financial situation than experienced in most previous periods. While this ratio has clearly been worse (it reached a low of 1.69 in 1983), it is at its lowest point since 1988.
The deterioration of the times interest earned ratio is important to monitor because it has fallen so much even with very low farm interest rates. If rates were to increase, it would likely deteriorate further.
As mentioned earlier, interest expenses are only one component of debt service. Although it is sometimes possible to delay or lengthen repayment terms, farmers must generally repay the principal they have borrowed.
Because interest rates have been very low, it has been possible to borrow larger sums than would be possible with higher interest rates, so it is important to also consider principal payments.
The debt service ratio shows the ratio of principal plus interest payments to the value of farm production. This is a measure of the percent of the value of production consumed by debt payments.
Today the debt service ratio is 29%, and just entered the 75th percentile of the distribution. Like the times interest earned ratio, this value indicates poorer financial conditions than seen in most of the data. The last time that the debt service ratio was this high was 2002. Before that, one has to return to 1987 to find a debt service ratio this high.
Wrapping it Up
To date, financial conditions in the U.S. farm sector have remained relatively strong. However, based on the data examined here, there are warning signs that things may be shifting for the worse. Unlike the debt-to-asset ratio, both the debt service and times interest earned ratios indicate that financial conditions are as poor as any seen for some time.
As we noted above, there are several claims that can be made on the cash flows of the sector. Among these are by governments (taxes), capital investment, and debt service. Of these three, the only one that can be easily delayed is capital investment. We would expect that capital investment will continue to fall in the sector.
Further, cash rent is another expense that can be managed, and we would look for further declines in rents, or at least fewer farmers willing to pay high rents.
At present, interest rates are really low. This means that for a given amount of debt, the interest payment is quite low. Even so, interest payments are starting to account for a sizeable amount of cash flows.
While the debt-to-asset ratio is a commonly used measure of financial conditions, at the sector level it can be a bit deceptive because there are a lot of farms that have no debt.
For instance, in 2014, ERS estimated that 1.47 million of the nation’s 2.07 million farms had NO debt. As we have said many times, debts aren’t repaid at the sector level, they are paid by the farms with debt obligations. My reading of Kauffman and Clark’s recent article on the Kansas City Federal Reserve Bank’s Survey of Ag Credit Survey, suggests there are reasons to be a bit concerned about debt in the sector.
As a result of low interest rates, there has been an incentive to borrow. On the other hand, as farmers borrow more, the principal that must be repaid each increases, making a larger claim on sector cash generation. When one considers principal and interest payments, farm sector cash flows are as burdened as they have been in some time.
Whether these conditions will lead to large amounts of financial stress in the sector will be determined in large part by how debt and cash flow generation is distributed among the roughly 600,000 U.S. farms with debt.
Caution going forward would be appropriate.
Written by Brent Gloy, co-founder of Agricultural Economic Insights and contributor to Agriculture.com/Successful Farming