Farming is a tough business. Weather risk, volatile markets, potential trade issues, input costs, and the steep investment in land and equipment mean today’s farmers must have formidable management skills to weather the storms and grasp the opportunities.
In that context, your financial numbers are a lot like the numbers you get from the field, numbers like yield, input costs, scouting data and so much so more.
But when it comes to your management of the farm as a business, which numbers are best for ensuring your farm is on the track to profitability and sustainability?
The only good answer, say the financial experts, is that it all depends on the farm.
Fortunately, it isn’t all that difficult to decide.
Make your debt have real purpose
Perhaps surprisingly, the big number isn’t your total indebtedness, not because your debt level isn’t important, of course, but because the purpose of your debt can be even more so.
Anyone farming today has had to borrow to stay in business, says Theresa Wever, farm adviser, financial planner and investment adviser with Wever Financial in Russell, Ont. Whether it’s a grain farm that needs land and machinery, or a dairy farm that needs quota, agriculture’s cost-of-entry is so stiff, it has to be paid for with someone else’s money.
Nor does it end there. Through most of a farming career, debt is a fact of life.
In fact, today, more farmers are borrowing more money later in their career than we may ever have seen in past.
But even here, there are trends and counter-trends, and the only way to know whether the debt load is right for the farm is to look at the right numbers, not just at the age of the farmer.
“There are quite a few people in their 50s who are, in fact, borrowing a lot,” says Wever. “But they may in fact be borrowing it for the next generation to be able to bring them into the farm.”
Other older farmers may be in investing in technology, including technology that reduces labour, says Wever. “Automation has a price tag.”
At the same time, many farmers easing into retirement are less willing to take on debt, given the risks, says Wever, who has worked for the last 21 years as a financial adviser and is now getting into succession planning.
But age alone isn’t the big factor, Wever repeats, “unless somebody doesn’t have a good plan.” A dairy farmer might invest in a barn, for example, with plans to eventually sell it. Or a farmer with children might plan to service the debt over 20 years.
Daryl Cousin, business adviser with Conexus Credit Union in Prince Albert, Sask., says succession planning is essential to help multi-generational farms manage risk. The retiring parents are “trying to push that expansion off to those kids,” he says, thinking the kids can take on the risk while the parents plan their retirement.
Cousin says lenders will take on a bit more risk with young farmers if they know the parents are strong and willing to help out the kids. “They might let them use a quarter of land for security to term out some of that current debt that they couldn’t afford to pay because they had (low-quality) crop.”
Know the debt-related ratios
What’s a good solvency ratio? Wever looks at liabilities divided by total farm assets, and she doesn’t like to see anything greater than 70 per cent. “If this was less than 30 per cent, that’s very strong.”
Cousin says they like to see a 0.5 to one debt/equity ratio, or less, in parents who are bringing their children into the operation.
But a son or daughter buying in is likely to be more highly leveraged.
“They could be in that one to one range, or even higher, depending how aggressive they’ve been in their expansion,” says Cousin.
He adds he likes to see a 0.65 to one debt/equity ratio for young farmers. Those numbers mean there’s some equity available for a cash injection or to refinance if the farmer has a bad year. That equity allows the bank to “term some current debt out to keep them going for another year or two,” he says.
A 0.8 to one, or one to one, debt/equity ratio is getting quite risky, he says. If the young farmer has a rough year and the parents don’t have land they own free and clear to back their kid, it could make it hard to pay down loans, he says.
If you’re a new farmer starting out, Cousin asks, how are you going to pay off a $100,000 debt to a crop input supplier if you have 25 per cent or more of your crop in the field?
It’s a tough situation no one wants to think about. But given last year’s nasty fall that forced many western Canadian farmers to leave crop in the field, it’s prudent to run through that scenario.
Wever also recommends watching the debt-servicing ratio, which indicates how much cash flow is available to pay the debt. Wever says lenders usually use the following formula: Principal + interest payments on term debt and leases ÷ net farm income + gross non-farm revenue + depreciation and interest on term debts and leases. Anything at 25 per cent or less is good, she adds.
Cousin likes to use five-year averages for debt-servicing projections because of market fluctuations. A five-year average should tell him how the farm does in a good year and a bad year. That way, he and his clients can prepare better for whatever comes down the pipe.
But a basic five-year average is misleading for an expanding farm, as the income would be low, and the debt levels wouldn’t make sense. So Cousin breaks down income and expenses per acre for each year. That tells him exactly how much the farm netted per acre over the last five years, a number he can use in his projection for an expansion year.
Another ratio to watch is the current ratio, which measures liquidity. Divide current farm assets by current farm liabilities to figure out the current ratio, Wever says. She adds it should include assets that can be liquidated easily, plus cash.
Wever says a farm’s current ratio shouldn’t be lower than one. Anything between one and 1.5 is considered stable, she says. “If it’s anything higher than that, you’re looking pretty strong as far as the banks go.”
Cousin says a farm’s current ratio will depend on whether they’re expanding. When a farmer is established, a good current ratio is 1.4 to one. “If you’re in expansion, ” he says, “it might be a little tighter because you’re spending money to grow. So you might be closer to that 1.25 to one.”
As well, a farm that expands one year, for example, will have expenses to get the next year’s crop in, but not have the inventory to back it up. Cash will be a little tighter in these operations, and that will affect the current ratio.
Controlling expenses and measuring return on assets
Exactly how a lender will measure profitability depends on the farm, Wever says, but a look at the return on farm assets is common, and how this is calculated will depend on whether farmers own or lease most of their land. If most of the land is owned, the lender will probably crunch the numbers with this formula: (net farm income + interest expense – your salary from the farm) ÷ farm assets.
In this case, anything less than one per cent is not great, Wever says. Between one and five per cent is pretty good, and Wever figures the average is probably around two per cent. Over five per cent is very good.
A measure of financial efficiency is the operating expense/revenue ratio: Operating expenses (minus interest and depreciation)/revenue. This is often where differences in management show up, says Wever.
“If they’re spending too much on expenses, then they don’t have any extra cash flow usually,” she says. Wever puts the average at between 55 and 60 per cent. Anything over 70 per cent doesn’t leave much money to live on, especially if the debt servicing ratio is around 25 per cent.
Conversely, a farmer with a higher debt load would likely have to reduce operating costs in order to service that debt, she adds.
Cousin says farmers should really be watching their expenses these days, “where can they save, where can they cut, because margins are getting smaller every day.”
For example, farmers might want to stick to one seed drill and run it for longer hours rather than buying two, Cousin says. He has clients that run 20 hours during seeding, and some have even run 24/7. He says it works, but it’s hard on the operator. There’s a higher chance of a wreck as the operator gets tired, and the operator will need help filling the drill in the middle of the night. However, using one drill to seed the whole farm keeps the capital outlay and debt low, Cousin points out.
Capital expenses will vary depending on where the farm is, Cousin says. As an example, farmers in southern Saskatchewan can cover more acres with a combine than their northern neighbours because fields in the south are larger and more open. Longer harvest windows in the south help as well.
Cousin wishes more farmers would pay attention to their capital expenses, and use software to track expenses and revenues, rather than pen and paper. Accounting software will crunch the numbers during each quarter.
And farm consultants are now using web-based programs to measure expenses and revenues on a per-field basis, so farmers know which fields are making them money. Those services could give farmers “a real-time idea of where they’re at, instead of waiting until the end of the year,” says Cousin.
Think through the options
Rising land prices and improved farm management have allowed farmers to take on more debt, Wever says. But as a former banker, she does think some are carrying too much debt. She’d like to see farmers focus more on debt repayment and diversify investments outside the farm.
She acknowledges that people might see that advice as slanted, since she also deals with investments, but investing off the farm eases farms through succession.
“But farmers are notorious for putting everything back into the business, which is their strength and their weakness,” she says.
Most lenders go through the key ratios with their clients before lending money. They also usually run through different projections to make sure clients can service the debt at higher interest rates, for example.
Wever thinks it’s important for farmers to look at the alternatives before making a big business decision. Farmers need to understand how long it’s going to take to pay off that debt and how that will affect the next changes they want to make to the operation. They need to think about whether they’ll still be okay with that decision in 15 years, she says, “because you’re now borrowing perhaps for yourself and the next generation.”
For the younger generation
This summer, consider signing your younger generation up for a course this winter on how to understand and use financial ratios.
If you are thinking about starting succession discussions, you might end up looking back at this kind of education as one of the best decisions you made.
Theresa Wever of Wever Financial says ratios can help the younger generation know whether their expectations are realistic.
In her view, that puts learning about ratios right up there with steps like leaving the farm and working elsewhere for a couple of years in order to generate an understanding of what it’s like in the real world, and to help the next generation find out for sure if they want to come back to the farm.
Successors must be able to understand the farm finances, Wever says. They need to know whether the farm can pay them, their parents, and any other siblings. They also need to know whether the finances will support expansion and other farm goals.
Understanding ratios is key to this. For example, Wever says, if operating costs run at 75 per cent, young farmers need to realize this only leaves 25 per cent for everything else, including their salary.
Equally important, however, is that young farmers also need to be able to assess a go-forward plan. Will it generate enough income to live on? Will it increase equity as quickly as needed? Can it survive back-to-back years of tough weather?
And most important of all, Wever says, they need to see ratios as tools to set measurable goals that everyone can work toward.
But it starts with learning. Or, more accurately, it starts with wanting to learn.
This article was originally published as ‘The Right Number’ in the April 2017 issue of Country Guide.