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Measuring Repayment Capacity and Farm Growth Potential

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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.

Article: Purdue Ag Barometer Report

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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.

Farm Financial Standards Council Releases Updated Financial Guidelines for Agriculture Document

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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.

FFSC Releases Free Implementation Guide

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(Menomonee Falls, WI — November 1, 2017) Never have the financial stakes been higher in agriculture, yet few producers have the accounting training to effectively monitor and control their expanding operations. In direct response to the Farm Crisis of the ‘80s the Farm Financial Standards Council (the Council) developed its Financial Guidelines for Agriculture. This document is designed to assist in developing sound financial statements on agricultural operations. However, direct adoption of the Guidelines by farmers has been hampered by two obstacles – understanding financial terms and not being accountants.

Get Our Free Implementation Guide

Download our free implementation guide for better financial decision-making.

For that reason the Council has developed and now released a 17-page Implementation Guide to assist non-accounting individuals in developing sound financial reports. It is available free of charge and is designed to be used in tandem with the Financial Guidelines and Management Accounting Guidelines documents available through the Council.

This is according to Jeff Bushey, CPA, a managing partner with Nietzke & Faupel, PC, an accounting firm in Pigeon, MI. As chair and a long-time member of the Technical Committee for the Council., he and fellow committee members are charged with keeping the Guidelines documents current and publishing revisions to them when deemed necessary.

“The first obstacle to adoption is often expressed as the question, ‘How do I get started moving beyond basic, mandatory tax records to meaningful financial reporting’?” Bushey says. “Most agricultural producers and lenders are already using some system to collect and report financial information with farm record books or record keeping software programs which are designed to provide information for two purposes: reporting federal income taxes, and; securing a loan from a financial institution.”

That information is required, at least annually, he explains. “With some additional information, the result can be a vastly-improved financial reporting program.”

This is compounded by a second obstacle: farmers and ranchers are great producers but generally are not accountants. “In a cost-versus-benefit framework, the cost is often considered too high to fully implement the Guidelines,” Bushey says.

“The new Implementation Guide is a simple way to learn how to use the Financial Guidelines. It’s written for a farmer using everyday terms,” Bushey explains. “The Financial Guidelines explain how to produce useful financial information. The Implementation Guide is a road map of how to get there.”This publication leads non-accountants in an abbreviated implementation of the Guidelines by applying a checklist approach and discussion of implementation issues. This checklist enables users to assess the information needed at the various stages of implementation and the benefits and costs associated with moving to each successive stage.

“Once they categorize their current level of farm records users can then begin advancing at their own pace through up to four stages of implementation,” he states. “For example, Stage I only requires a cash basis tax return, Stage II adds a market value balance sheet, Stage III incorporates cost basis valuation and Stage IV completes the process with double-entry accounting records.”

“The Implementation Guide suggests that producers don’t have to go all-in to benefit from partially implementing the fundamental financial reporting concepts discussed in the Financial Guidelines and that the recommendations are likely to be implemented in stages,” notes retired Purdue University Extension Specialist and CPA Alan Miller. He is also a long-time member of the Council’s Technical Committee.

He explains that as in any do-it-yourself project, a level of commitment will be required to achieve meaningful results. These commitments will often require changes in daily, or at minimum weekly, operating procedures.

“Family members and employees must also be committed to the timeliness, accuracy and discipline in gathering information and coding transactions to lay the groundwork for improved financial control and decisions,” Miller explains.

“Each producer must ultimately determine to what extent they will receive additional net benefits from adopting more of the recommendations.”

As farmers implement the Guidelines they can begin benefitting in these areas:
• Improve management decision-making and enhanced profitability
• Better lender relationships and access to capital
• Enhance production as well as financial understanding of their business
• Focus on strengths that set them apart from their peers
• Determine cost of production (through the Council’s Managerial Accounting Guidelines)
• Gain a better understanding of standard financial measures

“A fundamental concept of financial reporting is that accounting period profitability can only be measured accurately on an accrual basis. Cash basis income tax returns are not indicative of farm profitability,” Miller stresses.

“The net benefit of moving to the next stage — accrual-adjusted financial reports to assess farm profitability and financial condition — will be a huge improvement in the quality of information available for decision-making.”

Purposeful Loan Presentations; What You Say and How You Say It Really Does Matter

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By Tim Ohlde, President of Elk State Bank

People often joke about how much they detest public speaking. But for many, it isn’t a joke, they truly dread the thought of it. And, at least for some people right up there with public speaking is writing. Recently regulators have elevated the importance of loan write-ups; the financials will always be important, but the narrative is receiving increased review. Unfortunately, a fair number of loan officers dread writing. So, let’s discuss a few key aspects of the presentation content and how to elevate it to a highly effective level.

Make sure your Loan Presentation does Its Job – A good loan presentation provides a frame of reference for the borrower’s business, the current request and the relationship that the borrower has with your institution. It should set the stage for how this request fits into the broader scope of the operation and the long-term business plan. This might include referencing the complexity of the request and its size relative to the overall operation, the borrower’s management capacity and any competitive advantage that the business has in regard to product or service. At a minimum, it summarizes the request itself and makes a recommendation.

Remember Who Your Audience is – Typically the loan presentation is prepared for three different audiences. First, it is used by the lender to capture information and rationale for the decision on the credit request. Second, there is likely an internal or external loan committee or Board of Directors that will use it. Third, regulators will review at least a sample of loan presentations during exams. When studying a file, they will go to the loan presentation first and often review it offsite, so they read the loan write-up without bank staff available to answer questions. Make sure that what is written and the financial information included will be meaningful to all three groups. And one final audience that is hopefully avoided; a judge in a courtroom. Loan presentations may be requested by the court in the case of a dispute with a borrower.

Capture Context – If there is anything happening outside the borrower’s sphere of influence that may be impacting their business, make sure to reference it. Examples might be a significant change in their specific industry or the loss of a significant competitor.

Require Consistency – Having the same information, in the same format, presented in an organized and orderly fashion helps all audiences track key data. This is particularly powerful when external loan committee members and regulators are wanting to become familiar with the credit.

Develop a Format – Adopting a template for loan presentations that everyone within the institution will use builds commitment to improving credit file content. A presentation model is a tool that makes success in this area more likely. Having this agreed upon template is especially helpful when training a new lender. The model also allows for lenders to easily replicate static information that appears in each loan request. This would include the history of the operation and the background of key managers/owners.

Master a Writing Style – Strive for being succinct but thorough, focused and meaningful. Use words, tables, and formats that draw attention to key items and that lead the reader logically through the loan presentation. Use underlining, bold or italics to highlight key aspects of the financial information and demonstrate understanding of what they mean. The narrative should not restate financial data; it should expand on why and how financials have or will change. This is where a lender demonstrates depth of analysis. Less is more; extra words or uncommon words are undesirable; keep it clear and straightforward so the reader is focused on content, not extensive vocabulary.

Identify Financial Detail – Typical items to include, usually in charts or tables are; Balance Sheet trend analysis, Income Statement trend analysis, collateral coverage, ratio trends and repayment capacity. The repayment analysis will include sensitivity testing as well as timing of repayment based on a cash flow projection. These items usually culminate in credit scoring and/or grading and a summary of the overall credit risk based on the proposed request. Information about a guarantor, if there is one or if one is needed to recommend the loan, will be included because the guarantor’s financials will be reviewed as well.

Expand on Financials – Regulators and Loan Review Committee members are looking for the explanation behind the numbers as proof that the analysis was performed and understood. Back up the recommendation with the facts first, but evaluate context and add interpretations of the financial information.

Make a Recommendation – A summary section with the recommended action and rationale is a basic requirement so make sure that is prominent. This should include how the request scores within your risk rating system and any exceptions that might be necessary. Some institutions summarize the request and the recommendation at the beginning while others leave the recommendation to the end following the financial overview.

Find a Mentor – Look for a colleague who likes to write and organize information. This is the person to create the loan presentation template and to help review the final product for flow as well as missing information. It is hard to objectively review one’s own work; what may be apparent to someone with a long relationship with a borrower may not be obvious to someone taking a first look. After gaining experience, most lenders will outgrow the need for a mentor.

A commitment to exceptional Loan Presentations gets easier over time and reaps immense benefits when reviewing requests. It is also a great opportunity to deepen understanding of a borrower’s business and hopefully the bank’s relationship with them. As a lender strives to explain financial information an opportunity is created for rich and meaningful dialogue with the customer. Most lenders will always prefer numbers to words. But, the numbers alone can’t tell the whole story, the challenge of expressing what the numbers mean creates a better lender and a stronger loan.

Tim Ohlde is President of Elk State Bank based in Clyde Kansas and Founder and CEO of Country Banker Systems LLC, a Loan Analysis Software Product for Ag, Commercial and Consumer Lenders. Tim can be reached at HYPERLINK “mailto:timo@countrybanker.com” timo@countrybanker.com or 1-800-780-5479.

This article originally appeared in the Third Quarter 2017 issue of Ag Banking, a BankNews Media publication.  Copyright 2017 BankNews Media. All rights reserved.

Using Computers in ”The Future Farm”

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By Scott Sartor

In my last three blogs I wrote about the basics of modern technology, how to use data, and how to choose the software that best fits your farm business. So, what does the future look like for farms on the cutting edge?

The “Internet of Things” or “IoT”, is hardware that automatically collects and sends data from machines straight to a database in the cloud. This technology already exists and is used to track performance, costs of operation, and to troubleshoot mechanical issues. Agronomic software is getting to be even more precise… in fact, nailing down profitability to a field or management zone will not just be the standard, it will be necessary in the very near future. Of course, UAV’s AKA “drones” are going to be fully adopted by crop consultants, and will change the way they scout your fields. Robotic machinery will also be available.

There are some good cloud based farm management applications out there, and a few accounting tools are being developed to work with these apps. In the future, these agronomic and business tools will integrate for automated reporting so that you and your advisors can make quick decisions, while being confident in the accuracy of the data. This will shape how you market your crops, as cost data will be updated in a more expedient and accurate manner.

Right now, smart phones and computers are the primary access point for data consumption. The future will see more sophisticated smart phone use, then progress to cloud access via “smart windshields” on your equipment (IF you are driving), or a “smart desk” at your office, which are wired to the internet. According to the USDA Farm Computer Usage and Ownership report, U.S. Farmers are increasingly using the internet for business. Rural broadband initiatives are being funded by the federal government, so more reliable internet access will enable better cloud access. The future for farming looks very bright for those that adapt to technology.

Scott Sartor is a manager at K•Coe Isom. Scott developed Croptell, a web-based application that provides financial reporting and farm business intelligence to farmers, enabling time savings and better business decisions. Scott has worked with farmers and their financials – in risk management or finance for over 17 years — and stays passionate about technology because it makes operations more efficient. Follow him on Twitter @croptellScott.

Comparing Owner Equity

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By Alan Miller

One of the simplest ways to monitor farm financial progress is to compare the owner’s equity (or net worth) reported on the balance sheet at the end of one year to the equity reported a year earlier. If the amount of equity is larger, the farm made financial progress. Right? Perhaps! The farm manager should first determine the sources of the equity change.

One source of owner’s equity is contributed or “paid-in” capital. An increase in paid-in capital may indicate an increase in the farm owner’s wealth, but not an increase attributable to a farm business’ financial performance.

Gifts and inheritances are one potential source of paid-in capital, but they are not typically recurring. The farm owner cannot count on such increases year after year as a basis for building equity.

Another source of paid-in capital is nonfarm income and it may or may not be a recurring source of revenue used by a farm business. The implications for future farm equity growth are different depending on the likelihood of future infusions of paid-in capital. A key distinguishing characteristic of paid-in capital is that it wasn’t earned by the farm business.

It is important to separately recognize the contribution of paid-in capital to the total equity growth reported on the farm balance sheet. Usually items of paid-in capital are readily identifiable in the year they occur. Thus, they are usually relatively easy to sort out from the total change in owner equity.

Reporting a farm’s accumulated paid-in capital in its own separate balance sheet account is a good accounting practice. Tracking changes in each source of owner’s equity is a desirable alternative to lumping together equity from all sources. Lumping increases in paid-in capital together with other changes in owner’s equity can hide important management information.

Alan Miller retired recently from Purdue University after serving 36 years as an Extension Specialist in Farm Business Management in Kentucky, Alabama, and Indiana. He has been a Certified Public Accountant since 1991. At Purdue he taught an undergraduate course for agriculture students titled “Accounting for Farm Business Planning.”

“Windshield Metrics” blog 2 of two-blog series

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By Alan Miller

Let’s consider one windshield metric that I first learned to appreciate in the early years of the farm financial crisis of the 1980s. That financial measure is capital debt repayment margin (CDRM). This windshield metric can help provide direction where the farm balance sheet still looks great, but net incomes are likely to drop. For example, should you go ahead and restructure existing farm liabilities now in anticipation of tighter finances ahead? But, is it right for your farm?

If forecasted CDRM is a negative amount, loan restructuring will typically be easier to accomplish now rather than later. The larger the shortfall, or the longer it appears to you it might last, the more incentive you have to adjust now. The 1980s proved how quickly financial reserves reported on today’s balance sheet can erode if asset values soften, interest rates rise, or other financial adversity strikes.

CDRM forecasted for next year compares the sources of income expected to be available for repayment with the demands for repayment. These demands not only include interest and principal due on term debts, but also family living needs and planned expenditures to maintain farm capital assets.

In the 1980s even farms that started with little or no debt could end up having capital debt repayment problems because of these additional demands on repayment capacity. Estimating accrual-adjusted net farm income from operations for the year ahead is the starting point for computing CDRM.

The rest of my story is that I first started forecasting CDRM because a farm lending organization started requiring it in the early 1980s. I don’t remember it being a particularly popular requirement with my farm clientele, initially. However, those forward-looking estimates of CDRM really served the farmers well as the financial crisis of the 1980s deepened.

Could analyzing forecasted CDRM help you avoid disaster in today’s ag environment?

Alan Miller retired recently from Purdue University after serving 36 years as an Extension Specialist in Farm Business Management in Kentucky, Alabama, and Indiana. He has been a Certified Public Accountant since 1991. At Purdue he taught an undergraduate course for agriculture students titled “Accounting for Farm Business Planning.”

“Windshield Metrics” blog 1 in two-blog series

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By Alan Miller

Future accounting information is inherently valuable for decision-making because it is so relevant to the decisions we need to make now. Forecasted, projected, budgeted, or whatever you want to call it, future accounting information is never more valuable than when the economics of farming are in transition.

Any metric for measuring financial performance or financial condition can be forecasted. Forecasted financial statements are used in many situations to provide insights about what is most likely to happen to a business in the near future. I like to think of forecasted metrics as windshield metrics because they are forward-looking.

With historic or past financial metrics we are looking in the rear view mirror, so to speak, to assess trends in business performance over time and to figure how we got to where we are now. Windshield metrics add a whole new dimension to our management. They provide insight on what direction the farm business is headed and how we should manage in response. Windshield metrics should reflect farm managers’ expectations about what is most likely to happen during the year to come. Occasionally, forecasted financial statements and metrics are prepared for more than one year into the future. This is often recommended when a major change in a farm operation is being considered.

Forecasted income statements need to be accrual-adjusted to produce useful information, just like the ones for previous years. The easiest time to prepare a forecasted income statement for next year is usually right after the income statement for the previous year is completed. Remember to think about using windshield metrics as you plan for next year. In my next blog I will describe one of my favorite windshield metrics for periods of economic belt-tightening on farms.

Future accounting information is inherently valuable for decision-making because it is so relevant to the decisions we need to make now. Forecasted, projected, budgeted, or whatever you want to call it, future accounting information is never more valuable than when the economics of farming are in transition.

Any metric for measuring financial performance or financial condition can be forecasted. Forecasted financial statements are used in many situations to provide insights about what is most likely to happen to a business in the near future. I like to think of forecasted metrics as windshield metrics because they are forward-looking.

With historic or past financial metrics we are looking in the rear view mirror, so to speak, to assess trends in business performance over time and to figure how we got to where we are now. Windshield metrics add a whole new dimension to our management. They provide insight on what direction the farm business is headed and how we should manage in response. Windshield metrics should reflect farm managers’ expectations about what is most likely to happen during the year to come. Occasionally, forecasted financial statements and metrics are prepared for more than one year into the future. This is often recommended when a major change in a farm operation is being considered.

Forecasted income statements need to be accrual-adjusted to produce useful information, just like the ones for previous years. The easiest time to prepare a forecasted income statement for next year is usually right after the income statement for the previous year is completed. Remember to think about using windshield metrics as you plan for next year. In my next blog I will describe one of my favorite windshield metrics for periods of economic belt-tightening on farms.\

Alan Miller retired recently from Purdue University after serving 36 years as an Extension Specialist in Farm Business Management in Kentucky, Alabama, and Indiana. He has been a Certified Public Accountant since 1991. At Purdue he taught an undergraduate course for agriculture students titled “Accounting for Farm Business Planning.”