Making Good Decisions During These Good Times

By Betsy Jensen

The farm economy is strong, and many farmers are heading into unfamiliar or perhaps forgotten territory. After collecting disaster payments, farmers in the Northern Plains are finally able to see some profits.  Now the challenge is determining what to do with the money; hold as cash, pay down debt, or purchase assets. Of course there is always the option to spend it on a once in a lifetime trip to Borneo, but that is a family counseling discussion, and not farm management.   Pull out your most recent balance sheet, and follow along to determine where to put your hard earned money. 

Before you begin spending your hard earned cash, you first need to determine if there truly is any cash to spend. As a general rule of thumb, your current ratio should be at least 1.5, which means you have one and a half the current assets to current liabilities.  Current assets can and will be turned into cash within a year, and include items such as crop inventory, accounts receivable, prepaid expenses, and your checkbook balance. Current liabilities are those items which need to be paid within the year, such as an operating loan, principle and interest on term debts, and any outstanding debts. If you have $150,000 of current assets, and $100,000 of current liabilities, your current ratio is 1.5. That is the minimum you should have in cash, and there isn’t any extra money to spend on land purchases or machinery upgrades.

For low debt farmers, the current ratio is often high because there are few debt payments to make throughout the year.   As a double check to the current ratio, you should also make sure your working capital is at least 35% of your gross farm income. For the above example, the $50,000 in working capital (current assets minus current liabilities) will cover gross farm income of around $143,000.  If you have a bad crop, and crop insurance pays you 65-70% of your normal gross farm income, how are you going to make up the difference?  Cash can be king in some years, usually when you need it the most.

If you have finally determined that yes indeed, you have cash, now it is decision time. If you are planning a major expansion, always remember that cash is still king.  Do you have money to put towards your expansion, and still keep a little in the bank for a rainy day (either the rain won’t come, or it will all come at once)?  If you still have money to spend, take a peek at two of your efficiency ratios; interest expense and depreciation expense.  Those two will help determine if the cash should be spent to pay down debt, or buy new paint.

The interest expense ratio is Farm Interest Expense divided by Gross Farm Income, and it should be less than 8%. The depreciation ratio is Depreciation Expense divided by Gross Farm Income, and the ratio should be less than 5%.   Just remember that this is farm management and not tax management.  A good rule of thumb is 10% of your machinery value is the depreciation expense.  If you use tax depreciation, your ratio may be extremely high, especially if you utilize accelerated deprecation or Section 179. Tax management and farm business management can be quite different. 

The decision to buy land can be a little more complicated. If your interest expense is already high, purchasing land will only make it worse.  Of course not all debt is bad. Financial leverage is necessary for your farm to grow and expand, but it must be tracked.  If you are borrowing money at 8%, and the Rate of Return on Assets is 9%, you have positive financial leverage.  The higher you are in debt, the more important it is to track the return on assets. 

A good year in farming may need to get you through 5 bad ones, so it is important to make sure you make educated decisions, based on your farm financial analysis, and not based on emotions. An accrual adjusted income statement, instead of the cash based tax income statement, will help you analyze the current crop year, without clouding the data with numbers from past or future years.  It is easier to make bigger mistakes in the good years, when you are not backed into a corner. Make a good decision during good times, and reap the benefits during the not so good times.