Is it possible to make a profit and not have any cash?
Is it possible to make a profit and not get a good return on investment?
Is it possible to have cash without making a profit?
For farmer’s, sometimes unfortunately the answer is yes to all of the above! Danny Klinefelter, a finance professor and economist states that “early warnings can help farm businesses avoid the most serious damage in an economic downturn”. A farms ability to weather financial storms is significantly increased by analyzing good information, making the appropriate and necessary changes and not continuing with the same trend simply “because we’ve always done it that way”. The following points are some leading indicators of how to track the future performance of a farm business and have been adapted from a Klinefelter article.
Working capital and liquidity are extremely important. Cash is king, but a business can be making payments and going broke by refinancing, selling assets, building accounts payable, not revolving or building operating loan balances and deferring the replacement of capital assets or purchasing large capital assets with operating loan credit. The ratio of net working capital to gross revenues and net working capital to variable expenses is a much better measure of liquidity in agriculture than the traditional current ratio. Many farm operators have eroded working capital over the past few years and are now burning into equity.
Don’t over look the interest-expense ratio and term-debt coverage ratio. While interest rates have kept the ratio low in recent years, it is subject to very rapid change and the fixed rate market will move independently of the variable rate market and the Bank of Canada rates. Those who are highly leveraged or end up with carryover debt from operation losses can spiral down quickly with an increase in rates. The amount of debt with variable interest terms and the timing of fixed rate maturities is key to assessing the associated interest rate risk. The term-debt coverage ratio reflects the impact that capital purchases, and the associated term debt, have on the bottom line and the farms ability to meet cash flow requirements. Typically, that involves fixed debt servicing commitments which continue into periods when income turns down. The problems in low income periods are compounded by capital investments made primarily to minimize taxes or based on the assumption that good periods will last indefinitely. A wise farmer once said, “it’s not the 10 bad years that really hurt farmers… it’s the 2 good ones”!
Macroeconomic indicators, both domestic and global, need more emphasis. They can sound the alarm to changes at the Federal Reserve and Bank of Canada which affect interest rates, the dollar’s value and other early-warning indicators for health of the agriculture sector. For example:
The U.S and Canadian rate of GDP growth.
The rate of GDP growth in the emerging BRIC nations: Brazil, Russia, India and China.
The exchange rate for the Canadian dollar as it impacts commodity exports and imports, as well as the cost of imported inputs –fuel, fertilizer, etc.
The U.S. and Canadian unemployment rate given the growing dependence of farm households on off-farm income.
Domestic housing starts.
Prepare for bipolar markets. Unfortunately, markets tend to overreact on both the upside and downside of any cycle. Alan Greenspan referred to this response as irrational exuberance/fear and said psychology is 80% of market economics. When it comes to predicting financial problems, the debt to income ratio is a much better leading indicator than the debt to asset ratio and may indicate potential problems a few years earlier. The debt per unit, cash flow requirement per unit and equipment investment per unit are also good leading indicators of a farms ability to be resilient during down turns in the market cycle.
Land values reflect the ultimate financial health of a farm business. A high percentage of farm assets are in real estate. With the increase in land values in recent years, the total debt to asset ratio for a farm business may be at a historically low level, but the number can be very deceiving. Because a large portion of the net worth and the underlying collateral for many farm loans, including operating loans, is real estate, the value of land is critical to the risk of loss, in the event of default, faced by agricultural lenders. If land values drop and the loan to security ratio becomes a concern for creditors, a decrease in authorized credit or an increase is collateral may be required.
The market value of land is primarily determined at the margin – the price of goods bought and sold. If farm income drops and and debt serviceability problems occur, forced sales will increase. If able buyers get nervous about reduced income prospects and believe land values could fall, they will sit on the sidelines. This would exacerbate the problem and land values would fall even further. Changes in land values obviously are not evenly distributed and therefore land type, use, quality and location differ significantly, and so will the market impacts.
These observations not only affect farm income levels and asset values, but have a major impact on lenders and investors in farm assets. When credit is tight and investors pull back, it tends to exacerbate financial problems. The problems created are even worse for those who expanded rapidly prior to a downturn and younger farmers who have not had time to build sufficient equity to withstand negative shocks. Matters are further compounded by the fact that while income can fall quickly, the price of inputs and land rent usually lags.
If you believe in the saying “if it’s not broke, don’t fix it,” then you haven’t looked hard enough. Every management strategy is perfectly designed to give you the results you are getting. As farm business success becomes increasingly more dependent on strategic decision-making, analyzing trends in order to identify the early warning signs is critical.