As the Midwest agriculture sector faces another year of low profits, farmers need to take a closer look at their farm balance sheet, which is a snapshot of their financial condition on a specific day. The market-value balance sheet is based on the current value of farm assets owned, liabilities owed, and accumulated interest on liabilities. The difference between what is owned and what is owed indicates farm net worth. A farm balance sheet reveals a great deal about the farm's ability to navigate challenging economic times.
Green, Yellow, and Red Indicators
The market value balance sheet is one of the most critical pieces of information that a farmer will provide to a farm lender. The total of all liabilities divided by the total of all assets is the debt-to-asset ratio, expressed as a percentage. Lenders consider a farm that owes 30% or less of what it owns to be in a strong financial condition (a green light). Farms with a total debt-to-assets ratio falling between 30% and 60% will typically be financially rated in a yellow/caution condition, meaning that more attention will be given to ensure loan repayments are secure, especially at the higher end of the yellow range. The higher the percentage, the greater the concern over debt repayment.
If the loan application falls at the higher end of the yellow range on the balance sheet, other financial measures may be considered in determining the loan rating, and interest rates on loans may be higher. Some banks take on more risk than others and may only approve loans to borrowers with excellent credit scores. A younger farmer is more likely to have a higher debt-to-asset ratio than an older, more tenured one due to having more time to build wealth. Banks cannot discriminate against applicants based on their age; however, they will determine loan risk based on financial factors.
A debt-to-asset ratio of more than 60% will make it challenging to secure a loan through traditional lenders. Approval, if granted, will likely come at a significantly higher interest rate. A farm with a red rating may be directed to the Farm Service Agency of the USDA, as the lender of last resort.
Current Assets and Current Liabilities
Lenders may be concerned about the farm’s ability to pay its financial obligations during the year. The balance sheet categorizes what the farm can currently sell or quickly convert into cash to pay its debts within one year. Current assets include cash, accounts receivable, livestock that will be sold, an inventory of crops ready for sale or in the growing stage, and feed. Current liabilities include accounts payable, operating loan balances, and the current portion of long-term debt. It also includes other obligations, such as accrued interest and taxes that are due during the year.
The current ratio is calculated by dividing the total current assets by the total current liabilities. To achieve a green rating, the current ratio must be at least 2, meaning the farm has $ 2.00 to pay each $1.00 of current debts. A ratio of 1.3 or lower means the operation has $1.30 or less to pay for each $1.00 of debt and is considered risky. A current ratio between 1.3 and 2.0 falls within the yellow rating, as unexpected expenses or decreases in asset values, such as a decline in stored corn prices, could make it difficult to pay current bills.
Working Capital
Working capital is another balance sheet measure that lenders closely examine when rating loan worthiness and is related to the current ratio. The lender wants to be paid on time. Working capital is the cushion, in actual dollars, that the farm operation has above its expenses. A lender will typically require a cushion of at least 30% to 40% to cover unexpected financial challenges or to have a reserve to take advantage of opportunities that require cash.
Building a Strong Balance Sheet
The challenge for farmers, especially younger ones, is striking a balance between financial security and taking calculated risks. Having a strong cash position can lead to more loan opportunities; yet, taking risks to grow the business requires spending cash and taking on debt. However, having cash reserves allows growth, which can lead to higher profits for the farm. It is wise to continually evaluate the strength of the farm balance sheet before making purchasing decisions. Making purchases should be a good financial decision, not just a strategy to reduce taxes and hope for higher profits.
As machinery becomes more expensive, it takes more acres to generate the income to pay off the machinery debt. Keep in mind that lenders like a strong cash position. Your lender can be an invaluable advisor in the decision-making process. During especially challenging economic conditions, a strong relationship with your lender is imperative. Carefully consider the positives and negatives of borrowing from equipment and crop production companies.
Key Considerations
- Keep your lender fully informed about your purchase/debt plans, even if the purchase loan involves another lender.
- Use realistic asset values.
- Falsifying information on the balance sheet is a criminal offense. Farmers have been convicted and imprisoned for bank fraud.
- Your constructed balance sheets should be the same for each lender, and any changes made need to be documented. Due to inventory fluctuations, balance sheets can appear different from one day to the next.
- Correlate farm assets with loans.
- If a professional puts together your balance sheet, make sure you fully understand what each entry signifies and what financial ratios and measures represent. The more you are involved, the more you will understand. Your lender will appreciate your knowledge and be more comfortable working with you.
- Be truthful. False statements are more problematic than painful truths.
Kevin Brooks is a University of Illinois Extension Educator in Havana, Illinois, and can be contacted at kwbrooks@illinois.edu or at https://extension.illinois.edu/blogs/farm-coach.