Klinefelter: By the Numbers

By Danny Klinefelter
DTN Farm Business Adviser

Early warnings can help farm businesses avoid the most serious damage in an economic downturn. This article is the second in a series summarizing the responses of senior industry observers' to questions about how to track the future performance of the agricultural sector. Listed below are the final five of 10 bullet points summarizing those responses.

6. Working capital and liquidity are extremely important. Cash may be king, but a business can be making payments and going broke by refinancing, selling assets, building accounts payable and deferring the replacement of capital assets. So staying current on payments may not be enough by itself to keep borrowers' loans out of trouble. The Farm Financial Standards Council and others have found that the ratio of net working capital/gross revenues is a much better measure of liquidity in agriculture than the traditional current ratio.

7. Don't overlook the interest-expense ratio and the term-debt coverage ratio. While interest rates have kept the ratio low in recent years, it is subject to very rapid change. Those who are highly leveraged or end up with carryover debt from operation losses can spiral down quickly with an increase in rates. This has become more sure as lenders have moved to variable and adjustable rates, and shorter re-pricing and match funding. The term debt coverage ratio reflects the impact of farmers' tendency to make larger capital purchase and take on term debt during periods of high income. Typically that involves fixed debt servicing commitments which continue into periods when income turns down. The problems in low income periods are compounded by capital investments made primarily to minimize taxes or based on the assumption that good periods will last indefinitely.

8. Macroeconomic indicators, both domestic and global, need more emphasis. They can sound the alarm to changes at the Federal Reserve which affect interest rates, the dollar's value and other early-warning indicators for health of the agricultural sector. For example:

-- The U.S. rate of GDP growth.

-- The rate of GDP growth in the emerging BRIC nations: Brazil, Russia, India and China.

-- The exchange rate for the U.S. dollar as it impacts commodity exports and imports, as well as the cost of imported inputs -- fuel, fertilizer, etc.

-- The U.S. unemployment rate given the growing dependence of farm households on off-farm income.

-- Domestic housing starts.

9. Prepare for bipolar markets. Unfortunately, markets tend to overreact on both the upside and downside of any cycle. Alan Greenspan referred to this response as irrational exuberance/fear and said psychology is 80% of market economics. Experience has shown that when it comes to predicting financial problems, the debt:income ratio is a much better leading indicator than the debt:asset ratio. For example, agriculture's debt:income ratio indicated problems starting to develop in 1977, while the debt:asset ratio did not start reflecting any negative until 1981.

10. Land values reflect the ultimate financial health of the agricultural sector. The basic reason is 87% of total farm assets are in real estate. With the increase in land values in recent years, the total debt:asset ratio for the agricultural sector is at historically low levels, but the number can be very deceiving. First, 70% of farm operations carry no debt. The use of credit is more concentrated among capital intensive and larger operations that depend primarily on farm income for debt repayment. Most of the shift away from debt over the last 10 years has occurred in farms and ranches generating less than $500,000 annual gross sales while large farms extended their reliance on credit: Some 42% of land in farms is owned by non-operator landlords and of the 58% owned by farm operations, 61% is owned by farmers with less than $250,000 annual gross sales.

Because both the net worth and the underlying collateral for many farms loans -- even operating loans -- is real estate and because the majority of farm debt and farm income is concentrated on commercial scale farms and ranches, the value of land is critical to the risk of loss in the event of default faced by agricultural lenders. The market value of land is determined at the margin -- the price of goods bought and sold. If farm income drops and debt servicing problems occur, forced sales will increase. If able buyers get nervous about reduced income prospects and believe land values could fall, they will sit on the sidelines. This would exacerbate the problem and land values would fall even further. Changes in land values obviously are not evenly distributed. Land type, use, quality and location differ significantly, and so will the market impacts.

These observations not only affect farm income levels and asset values, but have a major impact on lenders, commercial banks, Farm Credit regulators and investors in farm assets. When credit is tight and investors pull back, it tends to exacerbate financial problems. The problems created are even worse for those who expanded rapidly prior to a downturn and younger farmers who have not had time to build sufficient equity to withstand negative shocks. Matters are further compounded by the fact that while income can fall quickly, the price of inputs usually lags.

EDITOR'S NOTE: Danny Klinefelter is a finance professor and economist with Texas AgriLIFE Extension and Texas A&M University where he teaches a beginning farmer program. He also is the founder of the mid-career Texas A&M management course for executive farmers called TEPAP. Grains Pro subscribers can access all of his columns online using the News Search feature under News.

(MZT/CZ)

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