by Michael Langemeier, Associate Director, Center for Commercial Agriculture

(Excerpt reprinted by permission of the author and Ag Banking Magazine. Find the full article here.)

Introduction

Repayment capacity measures include capital debt repayment capacity, capital debt repayment margin, replacement margin, term debt and capital lease coverage ratio, and replacement coverage ratio (Farm Financial Standards Council). Capital debt repayment capacity, capital debt repayment margin, and the term debt and capital lease coverage ratio address a farm’s ability to repay operating loans and to cover the current portion of principal and interest due on noncurrent loans such as a machinery, building, or land loan. The replacement margin and the replacement margin coverage ratio enable borrowers and lenders to evaluate whether a farm has sufficient funds to repay term debt and replace assets. For a farm to grow, it is essential that the replacement margin be large enough to repay term debt, replace assets, and purchase new assets, and that the replacement coverage ratio be greater than one. This article defines and illustrates the use of key repayment capacity measures.

Definitions

The capital debt repayment margin is computed by subtracting interest expense on term debt, principal on term debt and capital leases, and unpaid operating debt from prior periods from capital debt repayment capacity (accrual net farm income, off-farm income, interest expense on term debt, and depreciation minus family living expenses and income and self-employment taxes). The capital debt repayment margin enables borrowers and lenders to evaluate the ability of a farm to generate the necessary funds to repay the current portion of term or noncurrent debt. For this to happen, accrual net farm income, off-farm income, and depreciation have to be large enough to cover family living expenses, income and self- employment taxes, principal and interest on term debt, and unpaid operating debt from prior periods. It is important to note that the appropriate margin will vary among farms, and depends on the size of the farm and the type of enterprises produced.

The term debt and capital lease coverage ratio is closely related to the capital debt repayment margin. To compute this ratio, divide capital debt repayment capacity by principal and interest on term debt. A ratio greater than one indicates that the farm has enough funds to cover principal and interest on term debt.

The replacement margin and the replacement margin coverage ratio take the analysis one step further. The replacement margin is computed by subtracting cash used for capital replacement from the capital debt repayment margin. This measure enables a borrower to evaluate a farm’s ability to repay term debt and replace assets. It can also be used to evaluate a farm’s ability to acquire additional assets. Cash used for capital replacement can be measured using actual capital purchases (more specifically the portion of capital purchases that need to be paid for in the first year) or depreciation. The idea behind using depreciation is straightforward. Depreciation represents wear and tear, and obsolesce of machinery and buildings. Over the long-run, a farm needs to be able to replace machinery that is wearing out, to be able to afford new technology, and to be able to expand. We typically recommend using depreciation plus another 10 to 20 percent of depreciation as the farm’s measure of cash used for capital replacement to account for wear and tear on depreciable assets and farm growth. This amount will likely not be covered every year. However, over the long-run, it is essential that the replacement margin be positive. Without a positive replacement margin, a farm will not be able to fully replace depreciable assets or grow. Like the capital debt repayment margin, the replacement margin varies by farm size and type.

The replacement margin coverage ratio is closely related to the replacement margin. To compute this ratio, divide capital debt repayment capacity by the sum of principal and interest on term debt, unpaid operating debt in prior periods, and cash used for capital replacement. If the replacement margin coverage ratio is greater than one, the farm has sufficient funds to repay term debt and replace assets.

Find the full article at Ag Banking magazine’s Bank News website.

Reprinted by permission of the Purdue University Center for Commercial Agriculture

In April, the Purdue University/CME Group Ag Economy Barometer recorded the fourth largest one-month drop since data collection began in October 2015. The barometer, which is a sentiment index based on a monthly survey of 400 agricultural producers across the U.S., declined 18 points to a reading of 115, down from 133 in March.

This month’s decline in the barometer was driven by worsening perceptions of both current economic conditions and weaker expectations for the future. The Index of Current Conditions fell 21 points to a reading of 99, and the Index of Future Expectations declined 16 points to a reading of 123.

This month producers also expressed caution about making large investments in their farming operations. In the April survey, when asked whether they feel now is a “good time” or “bad time” to make large farm investments, only 22 percent of farmers stated it was a “good time” while 74 percent stated it was a “bad time.” That combination pushed the Large Farm Investment Index down 9 points compared to March.

Producers also expressed less optimism regarding prospects for resolution of the on-going soybean trade dispute with China. On the April survey, only 28 percent of respondents felt that the dispute would be resolved before July 1, down from 45 percent in March. However, 71 percent still feel the dispute will ultimately be resolved in a way that benefits U.S. agriculture. In a separate question, when asked whether they felt that the U.S. should rejoin the Trans-Pacific Partnership (TPP), 47 percent were favorable, 28 percent were not in favor, and 25 percent stated they were uncertain.

Since January, there has been an increase in survey respondents indicating they have concerns about commodity prices. As a result, we’ve been asking additional questions related to commodity prices in order to understand producers’ perspectives on the future direction of corn and soybean futures prices. For the past four months, those results have been compared with futures and options market-based probability estimates to determine whether there is a significant difference in sentiment between the producers and futures and options market participants. Early findings indicate producers have consistently been more pessimistic compared to those who participate directly in the futures and options markets. Moreover, producers became relatively more pessimistic over the course of the winter and early spring. This increasingly pessimistic view of corn and soybean prices may be playing a role in the reduction in barometer sentiment as well as the recent drop in both the Index of Current Conditions and the Index of Future Expectations.

Read the full April Ag Economy Barometer Report which is linked to the following address: https://purdue.ag/barometerreport. The report includes insights into producer’s year-over-year attitudes toward farmland values and a breakdown of the comparison between producers and futures market participants regarding the future direction of corn and soybean futures. The site also offers additional resources, such as past reports, charts and survey methodology, and a form to sign up for monthly barometer email updates and webinars. Each month I also provide a video overview of results from the barometer survey. That video can be viewed either directly on the Ag Economy Barometer’s website or on the Center’s YouTube channel at https://purdue.ag/barometervideo.

An updated version of the Financial Guidelines for Agriculture has been released by the Farm Financial Standards Council. With a January 2019 issue date, this 272-page edition replaces other versions of the document that have been in circulation since 1991. The most recent prior update was done in 2017.

Order the new version here.

“The members of the Technical Committee work very hard to keep the Guidelines relevant,” says Todd Doehring, Centrec Consulting Group, Savoy, IL, current president of the Council. “This has included changes to one of the case farms to reflecting changes in farm size, commodity yields, and prices as well as other inputs to the practical examples that make up so much of the document. In this case, we have integrated new pronouncements on Generally Accepted Accounting Practices (GAAP) in the treatment of deferred income taxes as well as terminology changes as market values is replaced with net realizable value with respect to inventory values.”

He says the most noticeable changes is a new case farm in Appendix A. This one is based on a Kansas farm business.

“It is our goal to take accounting principles and apply them to realistic farm production scenarios. It is especially helpful when users of the Guidelines can identify with the examples that are in the case farms in the document,” Doehring explains.

The purpose of the Guidelines is to help produce standardized financial statements of farm and ranch operations. It is available as a downloadable PDF here. The cost is $30 each for the Financial Guidelines for Agriculture as well as the Management Accounting Guidelines. Another document, An Implementation Guide, is available as a download at no charge. This is designed for those individuals without an accounting degree to better understand how to make the maximum use of the information in the Guidelines.

The Council evolved from the financial crisis of the 1980s and is an all-volunteer organization of farmers and ranchers, accountants, finance and tax professionals, academics, lenders, consultants, and organizations which produce agricultural finance software. Membership on the Council is open to anyone who has an interest in managing agricultural finances. There are currently over 150 members from all across the U.S.