It is stating the obvious to say 2010 has been a tough year for many grain farmers. Unseeded and drowned-out acres, poor grades and reduced yields have all had an impact on production and potential income from the 2010 crop. If you farm in the Peace region, it was nasty drought causing problems instead. Your questions now should be: “What has been the impact of 2010 on my financial position?” and, “What can I do about it?”
UPDATE YOUR NET WORTH STATEMENT
Your net worth statement is the starting point of analyses if you have any concerns about how things are looking financially on your farm. The net worth statement is only useful if it’s up to date, so get cracking.
For clarification, I use the term “net worth statement” to mean a statement of assets and liabilities based on current market value of the assets and “balance sheet” to mean a statement of assets and liabilities based on historical cost minus amortization/depreciation of the assets. Both statements are “right” but useful for different types of analysis.
You will still need to do an updated net worth statement for December 31 or at your business year-end, as usual, for your lender and for accrual adjustments, but preparing a statement now will help you get on top of things early. If you have last year’s statement to start from most changes will be to current assets and current liabilities. Also, be sure to update for any changes in machinery and land owned, as well as, paydown and new term debt and mortgages.
Get your inventory quantity and values as accurate as possible and don’t forget to include receivables, such as crop insurance and the government payment for unseeded/flooded acres if you haven’t received it yet. Other numbers to get as accurate as possible are operating loan (or cash) balances, trade and input credit and other accounts payable. See the sidebar for access to an Excel spreadsheet that will help put all this information in order.
WHAT DO THE NUMBERS MEAN?
Once you have your statement completed take some time to study and analyze it. I suggest you first look at the top section of your statement to determine your current ratio. The spreadsheet suggested in the sidebar will calculate this for you or you can easily do it manually or in a spreadsheet. Your 2010 cash income from your accounting software may not look that bad because you sold a lot of 2009 crop in 2010. Unless you do the accrual adjustments, current-year operating losses or poor returns will usually show up first in the top section of your net worth statement through lower crop inventory value, higher current liabilities or both. That’s why an updated net worth statement is a good place to start this early analysis.
The current ratio is calculated by dividing current assets by current liabilities. Current assets are cash and assets that will become cash in the next 12 months and therefore include grain inventory and accounts receivable. Current liabilities need to be paid in the next 12 months and include trade and input credit, operating loans and accounts payable. The current portion of term debt and mortgages (that is, the payments you need to make over the next year) are also included.
For grain farms, a current ratio of 1.5 or higher is considered good. If your current ratio is below 1.0 that is a serious concern as you can likely expect to have some serious cash flow problems ahead including needing credit to pay for a very large portion of next year’s expenses. A debt restructure is likely required to get the farm back on dry ground financially. A current ratio between 1.0 and 1.5 is generally considered in the “caution” area — in these cases I recommend very careful management of cash and completion of 12-month cash flow projections as a planning tool. In cases where the current ratio is in the caution range but closer to 1.0 than 1.5 a debt restructure may also be the recommended course of action.
AHARDLOOKATDEB T RESTRUCTURING
If your current ratio is a little weak you should next analyze the lower sections of your statement. How much of the value of your machinery is offset by term loans or leases? Is most of your equity in your land? What is your debt-to- equity ratio? To calculate the debt-to-equity ratio divide total debt by equity. With this ratio, the lower number the better, but there is more divergence of opinion in the industry on the break points between good, caution and concern. Generally a .42 or lower ratio is considered good. I consider a ratio of 1.0 to be pretty high for grain farms and cause for concern which means the range from .42 to 1.0 is my caution range. Some financial institutions and consultants use a slightly lower range and some slightly higher.
Keep in mind that you can have a strong debt-to-equity ratio at the same time as you have a very poor current ratio. What we are looking for in this analysis is to see if there is a good debt-to-equity ratio and the potential to restructure debt to fix the current ratio problem. Debt restructuring means taking current liabilities and “moving them down” the statement. In other words, taking out a mortgage on land and using the proceeds to pay off current liabilities and, in some cases, term debt for machinery.
Sometimes this is referred to as a “term out” or “refinancing.” Large corporations do it all the time, and in my experience there is both the need and potential to do debt restructuring on many farms. But I find farmers are often reluctant to restructure debt and prefer to tough out the current ratio problem and resulting cash flow challenges. Don’t get me wrong, that attitude is not all bad and I agree it is desirable to avoid having another mortgage. And our groPartners clients will tell you that I also believe in “keeping the pressure” on management to operate efficiently since sometimes after a debt restructure it can be too easy to take more current debt than you should. If machinery loans were also refinanced with a land mortgage it can be tempting to start trading equipment.
There’s no question it does take some discipline to manage finances appropriately following a debt restructure. However, the reason I think debt restructure is an option more farmers should consider is because I also believe that, in times like these with volatile crop and input prices, cash is king and being in a strong current ratio position can both make you more money and save you money over and over.
Completing a debt restructure properly can be pretty complex and I recommend farmers consider all their options carefully before taking this step. In most cases it is not just getting as much money as you can for the longest term possible. In fact, that is rarely the best approach! What I have found is that with the new-style mortgage products now offered by the financial institutions the ability to set up segments within a mortgage with different terms is very helpful as it can keep appropriate “pressure” on management for debt reduction and properly match debt to what it is financing.
For example, this type of mortgage would enable us to set up a three-or five-year segment for a portion of the new mortgage that is correcting the current ratio problem (by paying out current debt), another segment for say five or seven years to refinance some major pieces of equipment and a third segment at 15 to 20 years to refinance some land mortgages to reduce repayment requirements. Also, many of the newer-type mortgage documents are written so you can borrow back to the original amount after you have made some payments during good years. This feature gives us great flexibility and reduced cost and hassle in the future if (or when) we have another challenging year like 2010.
EarlSmithisvicepresidentandco-founder ofgroPartnersInc.,awesternCanadianfarm andlandmanagementcompany.AtgroPartners, Earl’sconsultingworkisfocusedon farmbusinessanalysis,financialmanagement andsuccession.Hewaspreviously manager,agricultureandagribusiness, PrairiesatRBCRoyalBank.ContactEarlat 403-586-2504or [email protected] withquestionsorcomments
Need a net worth statement? Start here
If you don’t have a previous net worth statement or spreadsheet to start from or want to do a very complete job, you can download a free Excel-based net worth template from Alberta Agriculture’s “Ropin the Web” at http://www.agric.gov.ab.ca. Click on the “Decision Making Tools” tab and then on the “Farm Management” link in the left side panel. The template is called the Agricultural Business Analyzer (ABA). Filling out a simple form will give you access to the full version that includes projections and the smaller net-worth-statement-only version which is all you need for what is suggested in this article. There are other options, if you’re willing to look or ask around.