AgDM newsletter article, May 2007
by William Edwards, extension economist, 515-294-6161, firstname.lastname@example.org
Columns about financial management on the farm usually appear when commodity prices are low, interest rates are high, or some other condition puts a squeeze on cash flow. Over the long run, however, how we manage when prices are high may have even more impact on the economic viability of the farm business. No one wants to miss the boat when prices are good, but sinking the ship is even worse.
Current grain prices are as attractive as we have seen for many years. And the best part is that they are caused by an increase in demand, not a short crop, as is often the case. If the world’s appetite for energy remains at current levels, high prices may persist. On the other hand, there are always some “old-timers” around who remember the late 1970s when export expansion fueled an explosion in farm commodity prices, and the U.S. was poised to feed the world for many years to come. A combination of factors turned the boom into a bust, and financial stress permeated the farm sector during the 1980s.
Are current conditions similar to the 1970s? The strong increase in demand for grains and oilseeds is similar, though for different reasons. However, we have not had any short crops or grain embargoes, and the general inflation rate in the economy has remained low and steady. The average ratio of farm liabilities to assets for Iowa farms in 1970 was 21 percent. By 1985 it had risen to 34 percent. At the beginning of 2006, though, it was only 11 percent. Most Iowa farms have a substantial equity cushion.
Grain farms, at least, are certainly looking at improved cash flows and farm income for 2007, barring severe crop losses. How should a bumper crop of cash receipts be invested? Here are some possibilities.
Pay Off Debt
Although the average Iowa farm has a low debt-to-asset ratio, there are still many operations that have substantial liabilities from purchases of land, livestock, machinery or other fixed assets. Paying off debt ahead of schedule will reduce interest costs down the road, and provide a cushion when leaner years return. Compare interest rates on all loans, and see which ones allow for early repayment without penalty. Remember that reducing debt carries a guaranteed rate of return equal to the interest rate on the borrowed funds.
Extra funds can be used to reduce operating lines, and create a larger credit reserve for emergencies. The “current ratio” is the value of current assets like cash, stored grain, market livestock and supplies, divided by debt payments and accounts payable that are due in the next 12 months. Most lenders like to see a current ratio of 2.0 or larger. The dollar difference between current assets and current liabilities is called “working capital,” and should be equal to at least 25 to 35 percent of annual gross revenues for most farms.
Many farming operations will look to replace depreciated assets such as machinery and equipment in the next few years. Instead of financing such purchases with credit, cash receipts may be sufficient to make the trade. Operators who have been leasing machinery may find this is a good time to switch to ownership and build up some equity in their equipment line. If cash is not sufficient to finance the entire purchase, a larger than usual down payment can make the debt easier to service in the future.
Land purchases look very tempting today, despite (or maybe because of) rapidly increasing land values. Increased revenue from high grain prices will eventually be bid into land prices and cash rents - it is happening already. Realistically, is doesn’t take any new management skills to produce corn and soybeans for ethanol or biodiesel, but it does take access to land. Thus, a larger proportion of net farm income will accrue to land ownership and a lower proportion will accrue to labor and management.
Budget carefully when financing land purchases. Will it take a profit margin equal to 2006 or 2007 levels to meet future payments? Or can you make it cash flow under more typical economic conditions? Farm land mortgages represent a long-term commitment. Purchasing fewer acres with a higher down payment can lower financial risk.
Rental rates have also been pushed up by bullish grain markets. Unlike land purchases, most leases obligate the operator for only one year or a few years. Given the uncertainty about where “fair” rental rates should be, many tenants and landowners have agreed on flexible cash rent agreements, with the final rent established according to actual prices and yields. The ISU Extension Ag Decision Maker website has more information on flexible leases (see Information File Flexible Farm Lease Agreements).
Spreading net worth over more crop acres can have the same “leverage” effect as borrowing more funds. The average net worth per crop acre for Iowa farmers is around $1,000. Values substantially below this mean that small variations in the market will have a larger effect on the farm’s equity.
Finally, it doesn’t hurt to have a little fun when extra cash is available. Take that vacation you have always wanted, or remodel the kitchen. You have earned it!
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