USDA recently estimated 2015 net farm income to be $56 billion, a 38% decline compared to 2014. Government payments are projected to account for almost 20% of total farm income. Income has declined over 50% since its recent peak of approximately $123 billion in 2013. 

Prospects do not look much better for 2016. Current Purdue estimates of crop returns suggest large losses per acre if all costs of production are included. Prices of animal products are also expected to drop in 2016 with tighter margins. 

Certainly, government programs in the form of crop insurance and farm program payments will continue to buffer the risk in farming, but they will not be as effective in reducing the downside risk as in the past. In particular, crop insurance revenue guarantees are substantially lower than during the high grain price years. 

Financially, many crop operations already had negative cash flows in 2015 in which cash out-flows exceeded cash in-flows. That situation is expected to continue for 2016 and some livestock enterprises are also expected to have negative cash flows. In fact, this narrow margin period could last for several years. So what are the implications of this reduced income period for the financial position and vulnerability of ag businesses and the conversations they will have with their lenders this year? 

It’s All About Working Capital 

Maintain your working capital! Given the lower incomes and potential losses farmers are facing, lenders will be particularly concerned about the working capital producers will have to buffer these losses. 

Working capital is the liquid funds that a business has available to meet short-term financial obligations. The amount of working capital a business has is calculated by subtracting current liabilities from current assets. Numbers can be obtained from your balance sheet. Current assets include cash, accounts receivable, inventories of grain and livestock, inputs or resources to be used in production such as feed, fertilizer, seed, etc., and the investment in growing crops. Current liabilities include accounts payable, unpaid taxes, accrued expenses, including accrued interest, operating lines of credit, and principal payments due this year on longer term loans. 

So how much working capital do you need? The answer to this question depends on both the risk and size characteristics of the business, and the volatility of the business climate. Larger businesses need more working capital, so it is best to determine the amount of working capital buffer relative to either gross revenue or total expense. A frequently suggested goal is a 15-25% buffer, or working capital that is 15-25% of gross revenue or total expense. A firm facing more volatility in the business climate needs a larger buffer. When margins for the firm are negative, these operating losses are typically covered by the use of working capital, resulting in a reduction in working capital (the speed at which working capital is reduced is often referred to as the “burn rate”). If margins are expected to be negative for more than a year or two, the burn rate on working capital may be relatively high, leading to a dramatic increase in the vulnerability to financial stress. Given the margin pressures and increased uncertainty that farmers are facing today, some suggest the working capital buffer should be 35% or greater in relation to gross revenue or total expense. 

Lenders today are increasingly concerned about the “burn rate” on working capital. Given the expected losses noted earlier, even those who currently have strong working capital positions might find it deteriorating quickly over the next couple of years. For example if crop operating losses approximate $100 per acre for the next couple of years, a relatively strong working capital position of $400 per acre today (which is approximately 50% of expected gross revenue) can deteriorate to $200 which is close to the level (approximately 25% of gross revenue) that lenders would consider vulnerable. 

How can you manage your working capital? Managing working capital involves maintaining an adequate portion of the asset base that can be easily converted to cash, and/or controlling the short-term drains on that cash resulting from debt service, capital expenditures, or cash withdrawals. So one of the easiest ways to manage working capital is to protect cash. When the business generates cash from the sale of products, it can be held in that form, committed to the purchase of inputs for the upcoming production season, or it can be used to purchase capital items or be withdrawn from the business. Purchasing assets or withdrawing cash from the business may be necessary in specific instances. However, it is extremely important in today’s environment to carefully monitor these uses of cash because their use can significantly reduce the liquid financial reserves of the business. Other techniques to preserve cash are to lease capital assets or hire custom services; to reduce expenditures that do not increase production; to improve yield through timely operations; and to sell at higher prices. Maintaining a strong cash position is an important way to manage working capital. 

In addition to the drain on cash and thus working capital from asset purchases or withdrawals, the repayment schedule on debt also has a significant impact on working capital. Shorter repayment schedules on debt used to purchase capital assets such as land and machinery results in larger annual principal payments and reduced working capital. Extending the repayment terms through refinancing can reduce principal payments and thus the pressures on cash flows, leaving more working capital to be available to buffer financial stress. If adequate collateral is available, the debt might be restructured with some of the operating line added to the term debt so that it can be repaid over more years, thus reducing current debt obligations and increasing working capital. 

Finally, it may be necessary to improve the working capital position by selling some capital assets – those that are not a critical part of the business such as a secondary farmstead or a vacation home might be first on the list. Maybe some less productive land has potential for development purposes. Alternatively, excess machinery and equipment could be sold. This strategy is often not the first strategy pursued, but in situations in which cash is relatively short, it should not be excluded from the toolbox. When selling capital assets, it is important to consider capital gains and losses, and depreciation recapture, which may trigger a tax obligation resulting from the sale of assets. 

Talking to Your Lender 

Communicate—Visit early and often with your lender concerning any events that might have an impact on your ability to repay your debts. Often when things are not going well, there is a very human tendency to avoid confronting the problem. Producers under financial stress will often immerse themselves in the day-to-day operation of their farm and ignore the long-term decisions that must be made. This can manifest itself in not telling the lender that there is a problem until it is too late. Early warning will give you and your lender the opportunity to jointly explore alternative strategies. It will also establish a better relationship for future credit requests when the situation has improved. 

Share Your Plans– Share your plans to respond to financial stress, and have some evidence to support their expected success. A sound and convincing business strategy will increase your lender’s willingness to extend additional operating credit, delay principal payments, or refinance existing debt. 

Prepare Detailed Financial Statements– Prepare detailed financial statements, and share them with your lender. At a minimum, this should include a current Balance Sheet, recent Income Statement, projected Income Statement for the next year, and Cash Flow projections. In this situation, it is important for the lender to be fully informed. The lender has become a de facto partner in your operation. Advice that he or she might provide or changes in your loan arrangements will be conditional on your financial situation. In addition, evidence that you are hiding information will result in inflexibility of the lender and could jeopardize your relationship in the long term. 

Discuss How You Will Control Risk– Discuss the ways that you will control risk. A variety of risk-reducing marketing strategies exist which use futures, options, and forward contracts. While some of these limit the upside potential of price increases, they also can secure a steadier stream of income for farmers. 

Other risk management strategies are contracts and joint ventures that share or transfer risk between multiple parties. It is important to note that no single party will be capable of bearing all of the risk in most cases. Thus, contracts should be written to allow re-negotiation of terms, should allow for variation in payments as market conditions fluctuate, or should share risk equitably between the participants. Such contract arrangements should be considered for leasing land as well as in producing livestock and crop products. Involvement in a contract where you shift all of the risk to someone else usually means that you have traded exposure to short-term price volatility for longer term risk of contract termination or default when price gets extremely low. 

Agriculture is going through a period of downward adjustment that has important implications for the financial position of ag businesses. This period may last several years and managers need to understand their working capital position and how to manage it. Lenders will become increasingly important in helping firms to manage through these tight financial times. So communicate with your lender early, communicate with them in detail about your financial situation, and communicate with them about your plans to manage through these times.