Farmers facing financial issues should address these issues as soon as they occur. In this case, Joe and Sally saw a potential problem and took steps to find a way forward. Although this example is a small farm, the issues and options are equally applicable to larger operations.
A farm couple that we will call Joe and Sally operate a rather small mixed farm on a partnership basis. They are middle-aged and have two children. They own four quarters, rent another two and have a 20 head cow-calf operation. They have 600 acres of crops and 360 for pasture and forages. Joe is a full-time farmer and Sally works part-time off the farm. They are concerned that they will not be able to meet their debt service obligations.
To address this situation they worked with a farm business consultant to analyze their operation and come up with options.
The first step in making any farm plan is to understand the owners’ personal and business goals. Joe and Sally want to improve their financial position so that they will be current with all their loan obligations and have adequate funds available for family living expenses. They also want to be able to purchase additional land for the cropping operation and/or expand their cow-calf operation as opportunities arise. Their ultimate aim is to retire at 65 and possibly have one or both children take over the farm.
Their total assets are about $700,000, total debt about $200,000 so their net worth is about $500,000. Thus net worth is about 70 percent of total assets, which is good. However, closer examination of their financial position shows that their current ratio (current assets divided by current liabilities) is 0.94 which means they have more short-term debt than short-term assets.
Current or short-term means something that is cashable or payable within the next 12 months. Continuing their existing operation “as is” for another year will result in a debt service ratio (debt service capacity/debt service requirements) of 0.96 which means they will not be able to make all their loan payments as come due. The debt service ratio should be over 1.0. A desirable range is anything from 1.3 to1.5. These ratios show that their concerns about not being able to meet current obligations (annual expenses and loan payments due within 12 months) are well-founded.
What are the options?
Joe, Sally and their farm business advisor generated several options.
1. Sell out: Joe and Sally could sell out, purchase a home in town, invest the residual equity and obtain non-farm employment. This option is not consistent with their goals and plans. As this is a third-generation farm, they would like to continue on with it if there is an opportunity to do so as a viable and self-sustaining operation. This option was rejected.
2. Add more off-farm income: Joe and Sally could continue on as at present but have Sally obtain full-time employment to increase her earnings. This option would improve debt serviceability and allow the liquidity problems to be resolved over time. However, as with option 1, this alternative is not consistent with the family’s goals and was also rejected.
3. Refinance: They could refinance existing debt over longer terms. This could resolve the present liquidity and debt service capacity problems but they would like to reduce debt as well.
4. Raise cash: Joe and Sally could sell a lake lot they own to reduce debt and increase the amount of long-term financing over appropriate terms. This option would reduce debt and address the liquidity and debt service problems that presently exist.
After some consideration Joe and Sally decided on the following course of action:
First, they decided to sell the lake property and use the proceeds to reduce outstanding short-term debt. They chose this course of action since the lake lot is not essential to their farming operation.
Then they made plans to restructure their long-term debt in a package that facilitates adequate repayment capacity. This involves retiring (paying out) two short-term (five-year) land loans and amortizing them over a longer period of time (15 years). This refinancing will lower their land mortgage payments and ease the demands on their cash flow. To reduce the increased interest charges that will result from the longer term, they will ask their new lender for annual penalty-free principal pre-payment privileges, as they hope to make larger payments once their finances improve.
With these changes:
- The farm should show increased profitability largely because debt will be reduced with the sale of the lake lot.
- Their debt structure and current ratios will improve, due to the refinancing and applying funds from the sale of the lake lot to existing debt.
- Joe and Sally’s financial structure will improve over time as profits are applied to further reduction of debt
- Their budget surplus should increase in future years (this is the amount that their debt service capacity exceeds debt service payments).
- The lifestyle ratio continues to be adequate in this plan. However, with debt service requirements now reduced more of the net income from farm and off-farm sources can be used for family life enjoyment, such as movie nights, weekend get-aways and annual vacations.
Listing a family’s goals and then examining their present financial situation makes it possible to develop alternatives that can meet the needs and aspirations of the family and maintain a sound financial structure.
Are you farming to live or living to farm?
Lifestyle needs are an important part of farm family life, but they are often neglected in business plans.
A farm should service the needs and aspirations of the family rather than the other way around. A far-too-common statement by farm young people is “it’s all work and no fun, so why would I stay here?” If succession is to be part of the overall plan, fun family activities should definitely be part of farm life as the children grow up and even continue after that.
Find a farm business consultant at the Canadian Association of Farm Advisors website at cafanet.ca.