Financial Management During Hard Times

By: Joe Parcell and Ray Massey, Extension Economists

Agriculture producers today face many obstacles in achieving overall managerial success. Noneof these obstacles is greater than understanding the financial components of managing acommercial farm in today=s volatile environment. Rapidly increasing technology and changes infarm programs have increased the complexity of financial decisions. New technologies (e.g.,precision agriculture) require considerable initial capital outlays. Increased commodity pricerisks require better risk management of existing capital outlays. One of the most importantcomponent of financial management is securing an operating loan or line-of-credit to carry onannual production activities. Agriculture loan officers may be hesitant to provide you with thenecessary monies for an operating loan if your liquid assets fall short of meeting short-termfinancial obligations. This publication is intended to provide persons with a refresher onfinancial debt structuring alternatives to Aweather the times@ and to bring attention to some of theshort-falls of these choices.

The balance sheet (or net worth statement) provides a snap-shot of an agriculturalbusiness=s financial characteristics at a point in time. The balance sheet lists all that the farmbusiness owns and owes at that point in time. One financial relationship managers have to knowis assets equal liabilities plus net worth (referred to as equity). Assets are anything of valueowned by the agriculture business. Liabilities are those claims by non-owners on assets in thebusiness. Net worth is the claim of the owner on assets in the business. Both assets andliabilities can be classified as either current or non-current. Examples of current and non-currentassets and liabilities are listed in Table 1.

The income statement provides a snap-shot of how owner equity changes during a givenyear. The income statement indicates monies available after all costs of production, interestexpenses, and operator labor are subtracted from gross revenues for reinvestment into theagribusiness.

A large component of profitability is debt. Individual producer profitability is heavilydependent on the amount and cost of debt involved in the farming operation. There has beenconsiderable variability in interest rates for agriculture real estate and non-real estates assets overtime (figure 1). If the income generated from the agribusiness is inadequate to meet debt interestpayments, then the agribusiness will erode equity and may eventually be forced into liquidation.

A Look at Financial Ratios

Before evaluating debt structuring alternatives, a better understanding of what the balance sheettells us about the farm business is needed. Financial ratios help to evaluate the financial viabilityof the business, and these ratios help determine to what extent changes in capital structure wouldmake a difference in financial management.

The following financial ratios provide business managers and financial institutions an

indication of the financial strength of the business. The balance sheet provides information onbusiness solvency and liquidity. Solvency refers to the ownership in the farm business by ownerscompared to ownership by creditors in the farm business. Liquidity refers to the ability of thebusiness to generate cash to meet financial obligations or investment opportunities withoutharming the operations of the business. Following the description of these ratios, financingalternatives and examples are provided.

Working Capital

Working capital is a measure of a business's ability to deal with short-term financial obligations. A positive value of working capital indicates that the business can meet financial obligationscaused by price fluctuations or production uncertainties. Alternatively, a negative or successivedecreases in the value of working capital indicates that the business may not be able to avoidshort-term financial stress. In this situation, lenders will be reluctant to increase the debt level ofthe business.

Current Ratio

The current ratio is a measure of business liquidity - the degree to which current liabilities can bemet with current assets. The greater the ratio the greater the liquidity in the agribusiness. Forexample, a current ratio of 1.50 indicates that for every $1 of current liabilities the agribusinesshas $1.50 in current assets available. A general rule of thumb is to keep this number greater thanone. Values below one indicate nonliquidity or inability to cover current liabilities with currentassets. The Farm Financial Standards Task Force suggest a current ratio below one indicates afinancial situation in which the farm may be vulnerable to financial difficulties. A ratio abovetwo is an indication of financial strength.

Debt-to-Asset Ratio

The debt-to-asset ratio is a measure of solvency - the percentage of the business' value obligatedto financial creditors. For example, a debt-to-asset ratio of 0.45 indicates that creditors hold$0.45 of every $1 of assets in the agribusiness. As a rule of thumb, creditors would like for anagribusiness keep this ratio below 0.50. That is, given the basic identity of assets equal debt plusequity, creditors would like to see the owners have at least an equal share in the agribusiness.

Working Capital = Current Assets !! Current Liabilities

Current Farm Ratio = Current Farm Assets / Current Farm Liabilities

Debt-to-Asset Ratio = Total Farm Debt / Total Farm Assets

The Farm Financial Standards Task Force suggests a debt-to-asset ratio above 50% indicates afinancial situation in which the farm may be vulnerable to financial difficulties. A ratio below30% is an indication of financial strength.

The above financial indicators provide an indication of possible financial problems in theagribusiness. Each of the above financial indicators provide a benchmark for where anagribusiness (farm) should attempt to achieve. Liquidity and solvency are only two componentsof the farm financial situation, profitability and efficiency measures must also be considered inevaluating the whole farm financial situation. The following section provides a discussion ofhow changes in financial structure affect the financial indicators described above and financialprofitability.

The Effects on Financial Performance from changes in Interest Rates and Return on Assets

Table 2 describes examples of leverage descriptions under alternative financingsituations. There are two imaginary farmers described in table 2, Leverage Larry andConservative Carl. They each begin with the same size of farm and same amount of current andnon-current assets and have both been farming for fifteen years. Conservative Carl has beensuccessful at farming and has inherited some of this farm ground; however, Leverage Larry hashad some hardships from weather and did not have any land bequested to him. Therefore, Larryhas to borrow seventy percent of his assets, while Carl has to borrow only thirty percent of hisassets. As indicated in the AInitial Position@ column, Larry has a net worth of $300,000 and Carlhas a net worth of $700,000. Furthermore, the financial indicators for each operator are different.

The current ratio for Carl is greater than one indicating Carl could cover currentliabilities with current assets. Larry does not have sufficient current assets to cover currentliabilities as indicated by a current ratio less than one. Carl has positive working capital;however, Larry has negative working capital indicating he may not have the cushion necessary tosustain successive years of low production or prices where he will need to cover currentliabilities. The debt- to-asset ratio for Larry and Carl are 70% and 30%, respectively. Thefinancial ratios indicate that creditors have more invested in Larry=s business than Larry does, andCarl has more invested in his business than creditors do.

For the AInitial Position@ there are four separate scenarios that could occur during the nextproduction period. The four scenarios are good year and low interest rates, good year and highinterest rates, poor year and low interest rates, and poor year and higher interest rates. Theinterest rate on non-current liabilities, for example, land, is held at 8% due to the long-term fixedrate common with these types of investment. The scenarios are listed below.

Good year - low interest. When asset earnings were high and interest rates low,both Larry and Carl seemed to be doing well. Carl made more money than Larry,but Larry seemed to be making good financial progress.

Good year - high interest. When economic conditions changed, interest ratesjumped to 12% on current liabilities. This had a serious impact on Larry. His

earnings were more than cut in half, and his lender became concerned with hiscash flow. Carl had to make greater interest payments and had less left over butstill had his head above water.

Poor year - low interest. Both farmers faced a poor year of low asset earnings. Larry has a problem, he cannot meet his cash flow needs. Carl and his lender,however, are confident that prices and production will rebound and that Carl canimprove on his cash balance in the years ahead.

Poor year - high interest. When the worst happens - low asset earnings and highinterest rates - how do these farmers fare? Larry has severe financial problems. He lost $20,000, and he realizes he may not be able to survive another year likethis one. Larry is eroding equity by continuing farming. Carl and his lender areconcerned, but they both know that Carl has some cushion to survive a few yearslike this.

Debt Restructuring Help?

The biggest problem agribusinesses face during economic stress is their ability to create revenuesto meet current financial obligations. Typically, current liabilities for the agribusiness refer toannual operating loans and current portion of long-term debt required for the operation of thebusiness. Interest rates on these loans are typically higher (figure 1) and the period required topay back the loan is typically less than one year. Two scenarios of financial restructuring aredetailed below. The agribusiness may consider either of these in the financial managementdecision process. These scenarios are used to show agribusiness managers the advantages anddisadvantages from choosing either of the scenarios.

Refinance $100,000 of Current Liabilities as Non-Current Liabilities

The second complete column titled, ARefinance $100,000 of Current Liabilities as Non-Current Liabilities@ is the restructuring alternative whereby both Larry and Carl decide torefinance to weather the times. This choice may have provided Larry and Carl short-term stayingpower by increasing working capital; however, farm profitability and financial efficiency will beeffected by these changes. The impact to the entire farm needs to be evaluated beforeundertaking in any changes in financial structure.

Good year - low interest. Relative to before financing, both Larry and Carlimproved their income due to paying a lower interest rate on the moniestransferred from current to non-current liabilities.

Good year - high interest. Relative to before financing, both Larry and Carlimproved their income due to paying a lower interest rate on the moniestransferred from current to non-current liabilities.

Poor year - low interest. Relative to before financing, both Larry and Carlimproved their income due to paying a lower interest rate on the moniestransferred from current to non-current liabilities.

Poor year - high interest. Relative to before financing, both Larry and Carlimproved their income due to paying a lower interest rate on the moniestransferred from current to non-current liabilities. However, Larry is still infinancial problems.

For all four of the scenarios listed above, both Larry and Carl were better off than if they wouldhave not refinanced some current liabilities. However, Larry and Carl, and especially Larry, cannot continue to switch current liabilities into non-current liabilities. To do this would eventuallycause non-current assets to be fully leveraged. No lender would be willing to fully leverage non-current assets. Therefore, refinancing the business' non-current liabilities to reduce currentliabilities is usually used as a short-term fix for financial problems.

Sell $100,000 of Non-Current Assets to Reduce Current Liabilities

The third complete column titled, ASell $100,000 of Non-Current Assets to ReduceCurrent Liabilities,@ is the restructuring alternative whereby both Larry and Carl decide to sellassets to weather the times. This choice may have provided Larry and Carl short-term stayingpower by increasing working capital; however, farm profitability and financial efficiency may beeffected by these changes. The impact to the entire farm needs to be evaluated beforeundertaking in any changes in financial structure. For example, capital gains tax is included inthe example here. This has a substantial impact on earnings. For years following the year ofrefinancing, capital gains tax would not be subtracted from ending income.

Good year - low interest. Relative to before financing, both Larry and Carldecreased their income due to decreasing their asset earning because less assetsexist to earn dollars. Additionally, capital gains tax further decreased income.

Good year - high interest. Relative to before financing, both Larry and Carlincreased their income because less interest was paid on debt financing due to theoverall reduction in debt; however, capital gains tax substantially lowered incomebelow pre-refinance levels.

Poor year - low interest. Relative to before financing, both Larry and Carlincreased their income because interest was paid on debt financing due to theoverall reduction in debt. Furthermore, relative to refinancing non-currentliabilities to reduce current liabilities Larry and Carl received greater income. Yet, capital gains tax on the sale of land lowered income in the first year.

Poor year - high interest. Relative to before financing, both Larry lost and Carldecreased the amount of money they lost because less interest was paid on debtfinancing due to the overall reduction in debt. Furthermore, relative torefinancing non-current liabilities to reduce current liabilities Larry and Carldecrease the amount of money they lost (year two forward). But, in the first year,capital gains tax reduced income.

For three of the four scenarios listed above, both Larry and Carl were better off, assuming capitalgains taxes are not included, than if they would have not sold; however capital gains taxsubstantially reduces income for both Larry and Carl the first year. Larry and Carl, and especiallyLarry, cannot continue to sell off assets. To do this would eventually erode equity. Furthermore,other assets may not be as productive due to the selling off of assets. For instance, Larry andCarl sell $100,000 of non-current assets. Each is selling off some of their productive ground. Therefore, this would effectively decrease their rate of return on assets. This has not beenaccounted for in the example above. If this option is chosen, Larry and Carl should considerliquidating their least productive non-current assets, e.g., least profitable parcel(s) of ground.

Summary

Solving severe financial problems sometimes requires drastic steps. The solutions proposed hereare directed at farmers and agribusinesses with very serious financial problems. People shouldrealize that many of these problems do not occur due to their management practices. Forinstance, low prices because of record production or poor production due to drought are just twofactors affecting financial well-being that are out of the hands of managers.

There may be alternatives other than debt restructuring that can help improve thefinancial position of the business. These include increasing income through off-farmemployment, refinance current and non-current liabilities when interest rates favor refinancing, orenter into a partnership. Additionally, group purchasing of machinery, renting land, or leasingmachinery may be a viable option for some in improving their financial position. OtherUniversity of Missouri Guide sheets can provide more information on any of these topics.

Production agriculture no longer relates strictly to focusing on production. Now,producers must become business orientated in making financial decisions that not only effect thebusiness today but in the future. In many instances reorganizing the financial structure of thebusiness to weather the times may require professional help. If you don=t ask, you may notweather the times of financial stress.

Table 1. Examples of Current and Non-Current Agriculture Assets and Liabilities.

Assets Liabilities

Current

Accounts payableNotes payable within 12 months

Principal payments onlong-term debt

Accrued interestAccrued tax

Non-current

Deferred principal owedDeferred accounts receivable

Deferred notes payableContingent income tax

Principal on-farm real estate

Current

Cash and checkingAccounts receivableCrops held for sale

Livestock held for saleFarm supplies

Value in growing cropsPrepaid expense

Non-current

Machinery and equipmentBreeding livestock

Movable farm buildingsFarmland

Permanent buildings

Equity (Net-worth)

Figure 1. Interest Rates on Agriculture Real Estate and Non Real Estate Loans (1987-1988).

Source: Minneapolis Federal Reserve Bank

Table 2. Leverage Example