Farming and the risk of insolvency: why cash is king

Grain farmers are in a time of unprecedented wealth. Increased land valuations and strong commodity prices have created a decade of compounding equity that has led many small enterprises to returns not usual in the farming industry.

This being said, one factor that has not improved in the past decade is working capital.

An industry that has seen a continuous run of strong years of revenue and wealth generation has actually declined when it comes to available cash flow.

The larger growing concern is that while cash has declined, the annual variable and fixed expenses of farm operations has doubled during this time.

A benchmark of large farms has determined that only 33 percent of next year’s total expenses will be covered by liquidity, while the remaining balance requires short-term financing. Leverage is becoming a daily discussion in today’s grain farming operations.

A farm income statement is typically split into three identifiable sections: gross margin; labour, power and machinery expenses; and land, building and finance expenses.

Gross margin

Gross margin encompasses the revenue earned from commodity production and sales, as well as the cost of crop inputs and other production expenses.

Commodity prices have been strong over the last decade and continue to be above average. Yield factors have also improved as technology, in both production and genetics, has led to higher yielding commodities. Diversification of crop rotations has also led to high revenues for many farm operations.

On the other side of the equation, production expenses have significantly increased. Fertilizer use has increased in many cases to help increase yields and other products, such as micro-nutrients, are becoming a new expense for many farms. As well, chemical use has increased for many farmers, who may have to apply numerous fungicide applications to their fields or make additional control passes to take out weeds and volunteer crops that have grown tolerant to traditional sprays.

Lastly, the increase in commodity prices has sparked an increase in seed costs. Overall, production expenses have more than doubled during this time of growth.

Labour, Power and Machinery Expenses

The second section, labour, power and machinery expenses, is the management function of the operation. These costs are mostly driven by ownership and producer decisions.

The largest increase to this area is machinery expense. In accountant terms, when cash becomes available to farm operations, many producers develop “iron disease.” The symptoms include significant increases in capital equipment through multiple equipment trades, which then increase depreciation and lease expenses on income statements. The shiny new toy factor has led to the most significant insolvency issue on farms because it not only increases the machinery expenses on the income statement but also requires additional after-tax cash for principal repayments on new financing.

Unless a producer has calculated his annual costs for repairs and maintenance and compared it to the additional new cost of iron, the machinery decision has not been made with a full understanding of the implications.

The other large cost in labour, power and machinery is the labour component. This does not include personal farm drawings but will encompass all third-party arm’s-length wages and custom work.

Labour is not often a driving force in cash-flow issues, but after analyzing the situation, many farmers often find that less equipment and more labour can increase profitability.

Land, building and finance expenses

The costs in this section are a component of the net wealth of the enterprise.

A young proactive farmer will often have high land rent and large financing costs necessary to expand and grow. A farmer nearing the end of his active farming days often owns his land and requires low financing, which reduces interest costs. Although this section has increased with the rising cost of land, the expenses here have grown much slower in the last decade than the other costs.

The largest risk to primary producers today is not bankruptcy but insolvency. The land wealth generation has made farmers equity rich, but profits and return on equity in the operating corporation (excluding land) have decreased on average. This has created the issue in which land equity does not convert to cash flow unless it is sold, as seen in situations where many large-scale producers require land sales to finance future crops.

When analyzing net worth and financial strengths, make sure to cover the working capital ratio and compare working capital to total annual expenses of the farming corporation. Having a strong net worth does not account for anything when cash is king.

Evan Shout, CPA, CA, is a business adviser with MNP’s agricultural services practice and can be reached at 306-664-8384 or evan.shout@mnp.ca.

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