The agriculture industry has experienced vast changes in commodity prices over the past several years. The U.S. average farm price of corn increased from approximately $3.00 per bushel during the 2006- 2007 marketing year to over $5.00 per bushel during the three marketing years from 2010-2011 through 2012-2013.1 During this period, the profitability of grain producers increased dramatically with consequential impact on the financial condition and spending patterns of farm operators throughout the Midwest. Balance sheets were strengthened as earnings and appreciating values increased liquidity, equity, and debt service coverage in the industry. As the income of grain farms increased, peaking at about $263,000 in 2012,2 production, land, capital expenditures (CAPEX), and living expenses increased during that time frame as well.
However, the years 2007 to 2012 were an aberration for the grain industry. As grain prices fell from stratospheric levels to below $4.00 per bushel for corn in 2014 and 2015, margin compression resulted in lower profitability, decreasing liquidity, and tighter debt service coverage for many in the industry. Once the final numbers are in for 2015, producers of milk, pork, and cattle feeders are expected to see profitability decline as well. Farmland value trends in the Midwest over the past year reflect some mixed results according to the Federal Reserve Bank of Chicago; however, in many regions, farmland values have either plateaued or decreased slightly over the past year. The outlook for 2016 indicates continuing challenges for profitability for many in the industry.
Institutions serving the agricultural industry have felt the impact of the above in the form of increased loan demand and loan/deposit ratios, which, by themselves, auger well for financial institution profitability. However, bankers surveyed in the fall of 2015 were expecting grain, livestock, and milk producers to struggle with profitability in the near term.3 Moreover, the majority of bankers surveyed are predicting loan repayment rates to decline this winter. If such prediction is accurate, this metric will be at its lowest point since 1999. In addition, bankers surveyed by the Federal Reserve Bank of Chicago predicted an increase in forced sales or liquidations of farm assets relative to a year ago. Agricultural economists are also predicting profitability challenges for cash crop producers this year.
Our numbers may be waning, but some of us still involved in the industry were Ag lenders back in the 1980s. The environment was vastly different at that time, particularly with regard to interest rates, which were considerably higher. However, as grain prices declined and production costs increased (sound familiar?) in the early part of the decade, the changes in the financial condition and cash flow of:
- University of Illinois, www.farmdocdaily.illinois.edu
- University of Minnesota, Center for Farm Financial Management
- Chicago Fed Ag Letter #1970, November 2015
Ag borrowers were very similar to those described above, especially for highly leveraged operators. The decline in machinery and land values reached historic proportions, precipitating the worst farm financial crisis in decades.
What did we learn from our experiences in the 1980s, and how can we use those experiences to navigate through the current challenges? The following is a summary of key “lessons learned” from that decade:
- When collecting financial data, do not “settle” for less than complete balance sheet and cash flow information.
- Throughout the life of the loans, monitor the financial position and progress of borrowers, including those who have only term debt.
- In the administration of the relationship, avoid overreliance on collateral values.
- Farmers are most susceptible to overleveraging and weak liquidity.
- Farmland values are susceptible to high interest rates and lower grain prices.
- Loan performance generally worsens faster than it improves.
- In analyzing the cash flow of the operation, be sure to quantify family living expenses.
- Keep in mind these famous words regarding CAPEX: “Will pick up custom work.”
Given the current environment, trends in Ag economics, and the knowledge gained from the economic stress described above, what are some best practices for moving forward in the administration of agricultural finance relationships and the administration of the agricultural portfolio?
- Use fiscal year-end balance sheets. This provides a consistent measuring means for analyzing the financial position and progress of the operation. It also facilitates the generation of accrued income statements.
- Use accrual income statements in measuring the profit of the operation from year to year. These can be completed with beginning and year-end balance sheets together with the borrower’s income statement. According to university research,4 the difference between the tax form Schedule Freported net income and the accrual adjusted net income can 4 Freddie L. Barnard, Professor, Department of Agricultural Economics, Purdue University be 50% or more. Is a difference of 50% in the analysis of the profitability of your farm clients good enough for your institution and its board.
- Encourage your clients to pursue opportunities to reduce costs of their operations. This is critical in the environment of “margin compression” in which we operate today. Ag economists relate that the focus should be on variable expenses, and 80% of the expense reductions may be realized in the top 20% of expenses.
- Work with the borrower in projecting a realistic cash flow and pro forma balance sheet for the year. Use this information to complete a sensitivity analysis or stress tests to evaluate cash flow workability should key factors that drive cash flow change to a material extent.
- Focus on cash flow and repayment capacity as the basis for credit.
- Obtain from the client and document the risk management strategy of the business for the coming year, particularly as it relates to insurance and marketing plans.
- Try to accommodate requests for restructure before the client has difficulty performing on loans.
- Itemize carryover debt and address with the client the driving forces behind it, plans for correction, and the optimum means to eliminate it.
- Pay close attention to liquidity. If the borrower is considering an expansion, encourage them to build working capital prior to doing so.
- Obtain loan guarantees when needed.
- Structure term loans to have payments due more frequently than annually if this is workable with the cash flow patterns of the operation. This can provide an earlier indication if performance issues exist and provide a slightly higher yield on the loan.
- Be proactive in identifying and downgrading problem loans. This has substantial and ongoing benefits in assessing risk in the portfolio, volume trends, and concentration issues that may be developing as well as providing senior management with the information necessary for the administration of the loan loss reserve and capital levels of the institution.
Another lesson from the 1980s is that most of the institutions that deployed sound practices in the administration of agricultural relationships as well as the loan portfolio overall were able to withstand the economic stress presented by that environment. It is important these practices are used in favorable times and adverse periods in order to provide a stable, dependable financial resource for the benefit of all stakeholders in our communities.