March 2, 2023
Financial Risk Management & Contingency Planning
Farming is never the same from year to year – sometimes prices are good, net farm income is high, and other times margins are tight. Planning ahead, or contingency planning for financial hardship is important for any farm operation. In this final episode in the Farm Risk Management podcast series, Purdue’s Michael Langemeier and Ed Farris join Brady Brewer to discuss financial risk management. How to evaluate farm financials, update financial statements, analyze performance, and when borrowing makes sense.
A Financial Risk Checklist pdf and the audio transcript can be found below.
00:51 Evaluate Your Farm Financials
04:17 Update Financial Statements
09:32 Analyze Performance
14:07 When Borrowing Makes Sense
This series is based on the Six Pillars of Farm Risk Management course, funded by the North Central Extension Risk Management Education Center. More information on contingency planning is on the Purdue Institute for Family Business’ website, https://purdue.ag/fambiz, under the Strategic Business Planning Focus Area tab.
Brady Brewer: Hi, and welcome to the Purdue Commercial AgCast, the Purdue University Center for Commercial Agriculture’s podcast featuring farm management news and information. I’m your host and joining me today is Michael Langemeier, professor of agricultural economics and the associate director of the Center for Commercial Agriculture, and Ed Farris, extension educator in Huntington County. On today’s episode, we will be discussing financial contingency planning. This is based on a course called the Six Pillars of Farm Risk Management, which is funded by the North Central Risk Management Extension Education Center. For more information on contingency planning , you can go to purdue.ag/fambiz, which is the Purdue Institute for Family Business website.
[00:00:51] Evaluate Your Farm Financials
Brady Brewer: Ed, thinking about financial contingency planning, why is it important to evaluate your financial standing?
Ed Farris: It’s really important to think about where your business is going, what’s happened in the past year, and thinking about things that would affect your bottom line. Number one is to think about the cost availability of debt capital. As we know right now, interest rates are on the upswing and it’s important you understand what rates you’re being charged? Are they fixed or variable? Is there an opportunity for you to lock in some interest rates before they continue to climb upwards? Is that something that you’ve had a discussion with your loan officer about?
And then second would be the ability to meet those cash flow needs in a timely manner. And this really goes hand in hand with thinking about your debt capital because if you come up to a situation where you wanna hold on to some grain and do some tax planning. You may want to adjust your operating capital and thinking about what that looks like holding that grain inventory and paying ahead some of those bills. This is a high profitability year. So that’s really critical to do as you look back in the past year.
Third thing is to think about the ability to absorb short-term financial shocks. One thing that comes to mind thinking about this, when I took the class with Dr. Robert Taylor, and he would say, "What are you going to do?" You know? That’s really something that you have to consider. What are those short term unexpected financial things that you can at least maybe think through and do some planning. If you did have a situation where you couldn’t unload your grain or you’re gonna have to pay out of pocket for some higher expenses. We got fuel and other costs that are continuing to go up.
The fourth thing would be thinking about are you really able to grow your equity and maintain it as a farm business? It’s one thing to cash flow the operation, but if you are not able to really take a good hard look at your financials and see if you are actually being profitable. Again, with the cost rising as they are this past year, these margins are thin in some cases. It depends on how you market your grain, if you’re a grain farmer. Or if you are a livestock operation, really looking at where are you at with your sales and your receipts along with your expenses to understand your true net farm income? If you are gonna be going into the negative, which in some cases can happen for the short term. You know, is this gonna be a long term thing or is this something that you can make corrections and look ahead to next year and think about what things you can do differently.
Brady Brewer: Contingency planning I think about what do we do if plan A doesn’t work out and on the finances, especially when you were talking about the ability to absorb short-term financial shocks, I think we’re seeing a lot of volatility in the markets today. You know, so understanding how much you can absorb and what you’ll do if those short-term shocks happen. I think it’s gonna be crucial for a lot of farm businesses.
Michael, I wanna turn now to you. Ed went over a lot of things that we need to be thinking about with the analysis, but all of these require financial statements to be created.
[00:04:17] Update Financial Statements
Brady Brewer: So what is a good frequency that we need to update our financial statements? And what financial statements do we need to have to have ready?
Michael Langemeier: Let’s start with some of the statements that are commonly prepared by farmers and then we’ll move on to the statements that perhaps they don’t prepare or don’t work on, but perhaps they should. We’ll start with a cash flow statement. Most farmers have very good records in terms of cash income and cash expenses because most farmers use the cash basis of accounting for their tax records. They’ll use QuickBooks or a program like that which does a good job of keeping track of cash income and cash expenses. And so summarizing that either quarterly, certainly at the end of the year, and also forming projections of your cash flow is something that most farmers can do because they have pretty good records in terms of cash income and cash expenses.
Secondly, most farmers have a balance sheet. All of those that borrow money for the most part have a balance sheet. And typically the balance sheet should be done at the beginning of the year and done at the same time every year. If you’re doing your balance sheet January 1, or as close to January 1 as possible in 2020, do the same thing in ’21. Same thing in ’22. Same thing in ’23. Because we’re gonna need that balance sheet in order to make a accrual adjustments, which I’m gonna talk about next, but also to look at changes in assets, changes in debt, changes in net worth over time. We wanna make sure that balance sheet is done at the same time every year. Balance sheets and cash flow statements are very commonly done by most farms.
Now let’s move on to some statements that are not as common. We’ll start with the income statement. Essentially what the income statement does is it takes the information from a cash flow statement, focusing on the farm aspect, farm income and farm expenses, and combines that with some accrual adjustments so we can calculate a accrual net farm income.
There is a lot more information on the Center for Commercial Agriculture website related to income statement, balance sheet, cash flow, and these other financial statements, so make sure you look at that if this becomes a little confusing. But essentially what you’re doing with an income statement is you’re looking at changes in current assets and current liabilities from the beginning to the end of the year. And you’re making adjustments to the cash flow so you can measure true profitability or the actual profitability for a given year. Why isn’t cash flow measure the actual profitability? Well, we use the cash basis of accounting for tax purposes, which gives us a lot of ability to smooth income.
When you look at accrual net farm income, your income may not be that smooth because you might have a really good harvest one year and not so good harvest the next year, prices change, input costs change. So all these things are changing, and it’s lumpy. ‘ 21 to ’22 look like they’re gonna be pretty good years from a net farm income. 2020 was lower. 2019 was even lower than. ’23 looks like it’s gonna be lower than ’21 and ’22. You get the idea here there’s quite a bit of difference in profitability over time. Much more than there is when you look at net cash flow. And so that’s the income statement.
A couple other statements that I find very valuable. One of ’em is called the Statement of Owners Equity. Essentially what this statement is doing, it’s trying to reconcile the beginning and ending net worth on the balance sheet. Because we use market value balance sheets it really complicates things, and not to get in the weeds here, but there’s two big changes in net worth that we’re really trying to disentangle. One of those increases due to increases in land values. For example, land values went up 25 to 30% in Indiana from ’21 to ’22. That has a huge impact on your change in net worth in the ’22 balance sheet. And so we wanna disentangle change in net worth from change in net worth resulting in what I call retained earnings.
Retained earnings represent profits that are left in the business that we can use to replace assets that are depreciated out to buy new assets, make down payments on land, things like that. Also to make owner withdrawals for family living. And so we wanna really know how much of a change in net worth is due to profit that we’ve retained in the business and how much is due to changing land values. We can do that with a statement of owners equity.
The final one I wanna talk about here, just real briefly, is what I call the Sources and Uses of Fund Statement. This one’s my favorite financial statement. If there is such a thing. What this one does is it reconciles the beginning cash inventory and the ending cash inventory. That’s what accountants use it for. I use it for a lot more than that. I wanna know whether the net cash provided from operating activities, i.e. net cash flow from my business after I’ve subtracted how much for family living and things like that. I wanna know if there’s enough money there to pay my debt. That’s the amount for financing activities to repay principle payments on land, machinery, buildings, those kinds of things. Make sure my operating debt is paid in a timely fashion and to buy new assets. This is why I find this statement so valuable is we can answer that basic question, "Do I have enough net cash flow to repay debt?" and "Do I have enough left over to replace assets or buy new assets?" That’s why I get pretty excited about that financial statement is we can answer that question.
[00:09:32] Analyze Performance
Brady Brewer: Definitely a lot of statements to go over. So Ed, how can we use these financial statements? What’s some areas of these financial statements, or broad buckets, that we can look at to really get a good view of our farm.
Ed Farris: Brady, really what it comes down to is four key areas. We’ve got liquidity, solvency, profitability, and repayment capacity. And I’ll just talk about each one a little bit.
Liquidity would be thinking about your current ratio, which if you think about how your balance sheet is structured, that would be your current assets divided by your current liabilities. Current assets would be grain inventories, cash receivables, if you’ve got livestock that you’re marketing, things that are gonna be marketed in the next short time, you would consider those as liquid assets. And then your current portion of your debt would be things that are gonna be coming due in the next year, that you would have to pay. That could be the principle on debt on machinery or a land loan. And it also would be your operating loan that you would consider as part of that short term, current portion of your debt. So, getting that current ratio and liquidity is really gonna tell how well you’re gonna be able to withstand those shocks that come along. If there is a short term thing that you have to address. In the past year, I’ve had some farmers in this area have a lot of variability in what their yields are. There is some of this going on right now. So really to sit down and figure out, how are these things affecting my liquidity? I may have thought I had better yields than some of these fields than what I really did. And that could affect, you know, that current ratio right off the bat.
Brady Brewer: Now Ed, is there a particular current ratio we should aim for, especially as it relates to this contingency planning topic of being able to absorb these shocks, is there a particular ratio you would advise farms to look at?
Ed Farris: It’s a great question. To be in that two to one range. So, if you have a $100,000 of receivables and inventory, and then you have $50,000 against it, that’s a good level to be at. I think when you get below that, is there an opportunity and is there a way I can improve that current ratio? Is it really necessary for me to be paying off this debt so quickly? Maybe I can restructure if you do come into a situation where you may have bought some equipment. Think about that and that affects the next one, which is solvency.
Which is the debt to asset ratio. Thinking about again just for simple measures, if you have a million dollars in assets and $500,000 in debt against that, that’s gonna be 50%. So that’s where lenders probably see warning signs, not necessarily that it’s a terrible thing because there are some people that do well have a higher debt to asset ratio percent. But when you start get into that category that’s whenever you have to make sure you’re on strategy. If you bought a lot of of land recently and thinking about is that debt, do I need to refinance? Possibly. Maybe you set it up on a 10 year note and maybe you need to restructure to a longer term or something. We are going in a year of 2023, which is a good, predicted to be a lower profitability year.
So, that gets into the profitability. It’s gonna be different for every operation, what profit level you need because you do have to think about what is my current debt situation and how much income do I need service my debt. And thinking about what your family needs are. If you have outside income coming into the operation, which a lot of farms do, that does help. If you have health insurance is provided by an outside employer or if the business has to provide that. Sometimes you have these operations and multiple entities, where you may have multiple families involved in that type of thing. So you need to look at that income level to make sure that not affecting the current ratio simply because you’re not able to be profitable enough. Because eventually that is going to affect your balance sheet and then we get into the repayment capacity and how you can repay debt. An important piece because if you’re not able to perform on your debts, you’re gonna increase your operating line of credit, perhaps, because you’ve had some low profit years. Fortunately we were coming off of two really good, strong years, so people are not in that situation. But there are things to be planning ahead for and looking at these ratios.
[00:14:07] When Borrowing Makes Sense
Brady Brewer: So definitely a lot to analyze. If all the ratios are in line, and we’re got a good plan in place. We have a cushion. How do we evaluate a farm’s ability to increase debt and pay equity?
Michael Langemeier: Let’s start with debt. First of all, it’s very rare today to see a farm that’s growing or that’s gonna be around for 20-30 years to have zero debt. There are some farms obviously, that are that are phasing out of agriculture and there’s nobody coming back to the farm to take their place, they may be approaching that zero debt. But that goal is very uncommon anymore. So, why do people use debt? Well, people use debt to try to grow. They’re more able to buy assets, to buy land ,to rent additional ground, if they have debt. So given that it’s very common to have debt, how should we analyze whether the debt is working for us? Well, it’s really easy to say how we analyze this, but the key thing is having good records. Without the financial statements and the financial ratios that we just got done talking about, it’s very difficult to determine whether borrowing is working for us.
But if we have good records and we have these financial ratios, we can use some of the information that we’ve already talked about and one of the ways to look at that, and I’ll try to make this as simple as possible, is you’re looking at your rate of return on equity, excluding the increase in land values. And so in my retained earnings, or the earnings I have from my farm in relationship to equity, is that large enough to pay debt to cover the interest rate plus have some additional money there that I can use to expand my operation. So we’re looking at that relationship between return on equity and interest rate. And, and I can tell you that there’s quite a few farms where that’s not the case. Even over a 5-year or 10-year period. And so they’re actually going backwards in terms of borrowing money in some cases, and not all cases, but in some cases. This is not a no-brainer. It’s not every farm that has a situation where their return on equity is larger than the interest rate. And that’s so important to analyze that. And Brady, we’ve recently done a podcast related to increasing interest rates. This is gonna be more challenging as we move into ’23 with substantially higher interest rates than we’ve seen for quite some time. That’s really going to increase the impetus of increasing our earnings in relationship to equity to make sure that debt is working for us. If you have some rules of thumb about operating debt or rules of thumb about how much money you can afford to borrow on machinery or buildings or land. You have to rethink those rules of thumb because the world is changing when it comes to interest rates and so that’s the very important to keep that in mind.
This brings us back to something you talked about earlier. Both Brady and Ed. You talked about whole idea of contingency planning. One of the things you need to do if you are borrowing money, particularly if your solvency is a little bit higher than you’d like it to be and you’re really worried about your ability to repay debt, is you need to do some what-if scenarios. When you’re looking at cash flow projections don’t just look at one scenario. Say, well, based on prices in ’23, based on cost of production, from maybe the Purdue crop cost guide, this is what my cash flow looks like for ’23. You probably wanna look at a scenario where prices are lower than expected, and see if you can still repay debt. Particularly in this environment where interest rates are changing. It’s so important to do that. And then finally, I’d like to circle back to what I was talking about earlier when I was talking about the statement of owners equity, the importance of really trying to figure out whether part of our increase in net worth over time is due to profitability, that we keep in the business. These retained earnings. So profitability after I pay debt, after I take out money for family living, how much of my net worth is due to that? For example, if very little of our increase in net worth is due to retained earnings, we can’t bring someone back to the farm. You can’t rely on year in and year out increases in land values to survive. And so there is gonna be periods of time, 2014 to 2019 was an example of that, where land values are heading south. You’re not gonna get that bump in your net worth from increases in land values. Land values don’t always have to go in the same direction. So I come back to in addition to looking at this return on equity relationship to interest, we also have to look at, are mine retained earnings strong? And typically the retained earnings are really strong, particularly as a percent of net worth. For example, you have the ability to expand. That’s your signal that I have enough money to bring someone back to the business. I have money to replace assets and even buy additional assets. Buy a larger tractor, buy a larger combine. You rent additional acres . It sounds easier than it actually is, but having a good set of records and really digging into those records and looking at some of these relationships that we’ve talked about is really important.
Brady Brewer: Yeah, that retained earnings that you talked about, that’s the difference between a accrual income statement and cash income statement, right, is so important because that accrual is gonna be a much better proxy or approximation for what the retained earnings that you have, relative because cash can come from several places. You mentioned the land values increasing. If you think about uses and sources of funds. This statement of cash flows. You can be going up in the money you have, but it may not be because you’re profitable or it may not be because you have a return on the equity you’ve invested in your business. So, really important to analyze this from all different angles.
With that, we’ve concluded our conversation on financial contingency planning. For more economic information, please visit us at the Purdue Center for Commercial Agriculture’s website at purdue.edu/commercialag or you can go to the Purdue Institute for Family Business website at purdue.ag/fambiz. On behalf of the Center for Commercial Agriculture, the Purdue Institute for Family Business and the contingency planning team, I am Brady Brewer. Thank you for listening.