No grain movement means no cash flow for a lot of farmers. Declining prices compound the problem.
It doesn’t take long for insufficient cash flow to become a management challenge. The situation is difficult now but will become worse as we approach spring with operating loans at their limits. Farmers may be wondering what they should do. There are options.
Visiting your lender sooner rather than later is a good first step. Maintaining regular communication with lenders when facing financial challenges is critical.
Selling assets is an option, as is contributing personal money to the business.
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Another option, but not for everyone, is to have an individual or company invest money in the farm, which is referred to as equity capital.
Restructuring debt is a more common option. It moves some or all of a business’s current debt (to be repaid in the next 12 months) to long-term debt.
Typical types of current debt are an operating loan, accounts payable, commodity advances and the principal on long-term debt that is to be paid within the year.
Restructuring doesn’t increase a business’s overall debt, but it does increase its commitment to making related principal and interest payments.
The benefit is that inventory sales then become cash flow for operations instead of everything going to pay current debt obligations.
If the original operating loan limit was left intact, those funds are also available to finance operations.
The farm should have the proven ability to be able to make the additional principal and interest payments. This may not be an issue for some farmers but could be quite a different story for others.
Lower crop prices are currently problematic for many farmers.
Today’s costs of production mean projected commodity prices and long-term average yields do not provide the profit margins needed to support additional debt repayment.
A farm’s repayment history can compound these problems because getting the restructuring in place may not be possible if it is weak.
Lenders usually demand additional security in the form of equity in assets when they perceive more risk.
Unencumbered assets are the best source of additional equity, but be cautious about mortgaging clear title land. The recent increase in land prices provides equity that could be used to secure new term debt associated with restructuring.
Farmers first need to determine how much working capital they need to finance operations this year. Examining past cash flow will provide a good indication as to what is required.
They can then arrange the restructuring accordingly, terming out enough of the current debt to end up with the desired working capital.
Producers should also test their farm’s earned ability to make the additional principal and interest payment.
First, they should determine their average net earnings (before depreciation and term interest) for the past three to five years. Divide this number by the annual principal and interest commitments before the restructuring. This is the existing debt servicing ratio.
Now, take the same net earnings but divide it by the annual principal and interest commitment, including the new restructuring commitments. This is the revised debt servicing ratio.
Compare the two. Try to keep the new ratio to 1.5 or better, which is $1.50 for every $1 of principal and interest. Allowing the debt servicing ratio fall to $1.25 or lower as a result of restructuring can be problematic over the life of a loan.
Restructuring debt is a common practice and may be a good option.
However, whether farmers choose to restructure or consider other options to help them get back on solid financial ground, there are pros and cons. It’s important to consider each option carefully and seek professional advice from lenders and independent farm management advisers who can help make the best decisions for each specific circumstance.
I recommend that farmers think carefully about debt restructuring. If they are going to take this step, make sure not to just apply a Band-Aid in the short term. Consider the longer-term implications.
