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Virginia Cooperative Extension -
 Knowledge for the CommonWealth

Is Virginia Facing Another Agricultural Crisis?

Farm Business Management Update, August 1999

By Gordon Groover of the Department of Agricultural and Applied Economics, Virginia Tech

I have attended a number of meetings over the last 6 months where the phrase "agricultural crisis" has been used frequently by individuals from all over the US. Virginia producers are approaching the fall harvest season with historically low prices for grains, oilseeds, and cotton and tobacco quotas that have been drastically cut over the last few years. Low prices coupled with the drought conditions in some counties will lead to disastrous financial conditions, such that farmers may be unable to cover their out-of-pocket production costs. Answering the question "Is this another agricultural crisis?" is of little concern to individual farmers facing the prospects of not meeting cash flow requirements for the remainder of the year and decisions about the long-term viability of their farm operations. I do not mean to minimize the importance of this question, but more importantly want to address the options, alternatives, and strategies available to farmers who find themselves in a crisis.

Know What's Important in Making Decisions Making informed decisions is "management." Decisions need to be made based on sound information about the farm business and the family financial needs. If a producer has detailed financial record records for the farm and family, and production records, they have the necessary information to begin developing strategies to address the crisis. What if they do not have detailed records of the farm business and family? First, producers don't need to feel guilty. A large percentage of farm business managers only keep records to meet the requirement for filling state and federal taxes. Tax-based records provide a useful starting point for development of the necessary information for addressing the crisis.

Necessary information: The following information is necessary for supporting short and long-term decisions for the farm business:

1. Previous 3 years income statements' or federal tax returns for the same period. This set of data will provide a listing of cash and capital sales and expenses for the farm business.

2. Net worth statements (balance sheets) for the last 3 years or a listing of all debts and assets owned by the business and family.

3. Production records detailing land use and total production (tons, bushels, pounds, head, etc.) sold for each of the last 3 years and if possible yields per unit, e.g., bu./per acre or lbs. of milk sold per cow.

4. Family financial records listing family monthly or annual costs-of-living, including off-farm income and contribution to retirement accounts and investments.

If producers have difficulty getting this information together, they may want to check with their lenders to see what supporting records are in their files. Producers should discuss their need for information as supporting documentation for making improved management decisions and evaluation of alternatives with your lender. Many lenders require that producers provide a net worth statement annually and a listing of income and expenses. In addition, all lenders can provide borrowers with a current balance for all loans. However, this request may carry a processing fee. In addition, Virginia Cooperative Extension has 11 Extension Agents specializing in farm business management that can be contacted through your local extension office.

Analyzing the results: Once the necessary information is collected and you have developed net worth and income statements and family living costs, a number of analysis factors and published data sources should be used to determine the overall financial health of the family farm business. Use of finical ratios will help in analysis of your farm business to determine trends, show areas of strengths and/or weakness; however, they will not assist you in making the critical day-to-day decisions about how the business should be managed. Analysis factors only measure the success or failure of management to achieve their long-term goals.

Indebtedness ratios: A number of ratios give indications of the amount of leverage the family farm business has. Using information from the net worth statement and the income statement can assist in measuring the overall health of the farm business. The most commonly used measure of leverage is the debt/asset ratio calculated as follows:

Debt/asset = (Total debts total ÷ assets)* 100
All this information can be obtained from the net worth statement.

The debt/asset ratio is the most commonly used measure of overall farm leverage and indicates what proportion of the farm business is owned by the family. Having at least 3 years of debt/asset ratios will show a general trend of increasing, decreasing, or stable total farm debt. Farmers with low debt to assets ratios will have more cushion to sustain crisis years when additional borrowings are required to cover loses from low prices and/or yields. On average, U.S. farmers have a debt/assets ratio of 15 to 18 percent. However, this range depends on the life cycle of the farm business and if the farm business has just undergone an expansion of the business with increased borrowings for new enterprises. In most cases, farm business managers should seek to keep their debt/asset ratio below 50 percent. If debts to asset/ratios are currently greater than 75 percent or show an increasing trend above 50 percent, plans should be developed to reduce debt and to explore alternatives to the current enterprise mix.

Current Ratio: The current ratio measures the availability of cash to cover debts that are due within the next 12 months. Data to calculate the current ratio is obtained from the net worth statement and is calculated as follows:

Current ratio = total current assets ÷ total current liabilities
The current ratio is written as a ratio, e.g., 1:1.5 and interpreted as for every dollar of current debt, 1.5 dollars of offsetting current assets are available. Farmers should strive to have their current ratio greater than 1:1.5 to insure adequate funds to meet current obligations with a ready source of cash or resources which and be easily converted to cash. As with all ratios, a positive trend or stable trend in the current ratio is an indication of a healthy financial situation.

Operating expense ratio: This ratio compares total operating expenses to gross farm revenues. Data to calculate the operating expense ratio is obtained from the income statement and is calculated as follows:

Operating expense ratio = ((total operating expenses - deprecation) gross revenues)*100
The operating expense ratio is written as a percentage, e.g., 60 percent and indicates what proportion of each dollar in revenue received by the farmer is available for debt service, family living, and returns to management and capital. Farmers should strive to have their operating expense ratio less than 65 percent to insure adequate returns for family living, debt service, capital, and management. As with all ratios, a positive trend or stable trend is an indication of good cost control. An operating expense ratio greater than 80 percent indicates that the farmer may face some tough times meeting all requirements for needed cash flow and debt service.

Interest expense ratio: This ratio compares total farm interest expenses to gross farm revenues. Data to calculate the operating expense ratio is obtained from the income statement and is calculated as follows:

Interest expense ratio = (total farm interest expenses ÷ gross revenues)*100
The interest expense ratio is written as a percentage, e.g., 6 percent and indicates what proportion of each dollar in revenue received by the farm goes to pay interest expenses on debt. Farmers should strive to have their interest expense ratio less than 6 percent. This ratio is quick measure of total debt and can help indicate increasing debt service or increasing interest rates when data to develop an accurate net worth statement are limited.

Rate of return on farm assets: This measure of efficiency is the most comprehensive of the financial measures of efficiency or profitability of the farm business. Data to calculate the rate of return on farm assets is obtained from both income and net worth statements and is calculated as follows:

Rate of return on farm assets = ((net farm income - owner withdrawals for unpaid labor and management) ÷ Average total farm equity)*100
Rate of return on farm assets is written as a percentage, e.g. 6 percent. Note: Net farm income used in this calculation is determined by subtracting total operating expense from gross revenues and then adding the gain and/or loss from disposal of capital assets and changes in value of inventory items. This measure of efficiency indicates overall profitability of the farm business and should show an increasing or stable trend. The typical rate of return on farm assets for most farm enterprises is around 5 percent. Farm business managers should strive for positive rates, preferably greater than 5 percent.

Options

If the farm business is not meeting the producer's long-term goals for financial growth or shows signs of a weakening financial health, steps need to be taken to explore options. Listed below are some options that can be considered to help improve the overall financial position of the farm business.

Cutting costs: Managers should concentrate on the operating expenses found on the income statement. By listing the expenses from largest to smallest, producers can focus attention on the top five expenses. In many cases these five expenses may make up to 50 to 70 percent of total operating expenses. Producers can explore with their farm advisors and extension personnel ways to reduce costs without impacting output. For example, use of soil test records can show which fields may have high to very high levels of nutrients indicating that additional or normal inputs may not be needed for several years. In addition, when making decisions to purchase inputs for the farm business, producers should always ask if this expense will pay for itself. If not, they need to consider other alternatives or postpone the expense.

Refinancing existing debt: Refinancing is an alternative only when the farm shows long-term profitability and the existing debt structure (length of loans) is reducing short-run cash flow needs. Farm managers must work closely with their lenders to review all debt (farm and family) to consider the outcomes of refinancing existing debt. In some cases, the farm may have older debt at higher interest rates that could be refinanced to reduce total interest costs.

Disposal of unproductive assets: If cost cutting and/or refinancing are not sufficient to return the farm business to a healthy financial situation, disposing of unproductive assets should be considered. This decision is difficult to make, however. The same rule used in cost cutting applies here: "Does this asset pay for itself?" If not, selling the asset to generate additional cash flow to reduce debt or support family living expenses needs to be explored. Note that producers will need to consider all the legal and tax implications of selling an asset. If the bank has a lean on the asset, the producer will need to contact his/her lender to explain the reasons for the sale and get permission. Sale of assets may imply tax obligations that must be paid; therefore, some of the proceeds must be retained to pay state and federal taxes. Checking with a tax advisor prior to the sale is a must.

Reducing the size of the farm: In some cases a partial sale of cattle, machinery, and/or land may be sufficient to reduce debts to a manageable level if one or both spouses get off-farm employment. The farm then can be operated on a part-time basis retaining some land and family dwelling. In all cases, when considering this option, producers must check with their lenders, tax advisors, and attorneys to plan the reduction to minimize potential tax and legal problems.

Selling out: This choice is a "last resort" and is a painful process. However, in some cases, it cannot be avoided. Some very profitable farmers consider selling an option every year, that is, "Would I be better off financially and personally if I sold the farm and invested my money and talents in another activity?" Being forced to sell removes some of the flexibility to retain control of the situation and to preserve control of assets. Planning to sell for whatever reason may require more planning than starting a new farm business. It is absolutely imperative to consult with advisors that can help plot strategies to reduce the tax, legal, personal, and family stress associated with selling out.

Conclusion

Agricultural crisis or not, sound financial management and exploration of alternatives for the farm business are a must to survive the current drought and low commodity prices. Keeping accurate records and analyzing them to determine the financial stability of the farm business is also a must to make it through the next years of reduced farm income.

Contact the author at xgrover@vt.edu .

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