Growing up on a farm in the Midwest, I learned quickly that weather and commodity prices had a major impact on the economic success of farm families. I recall my parents talking about favorable years for feeding cattle that drove economic progress and enabled them to purchase various assets for the farm operation and the family.
Conversely, profit margins for grain and livestock producers were often tight because of what were often abundant supplies of commodities. This dynamic has driven, in part, the “margin compression” and profitability challenges the industry has faced in the Midwest since 2012.
In September, the Federal Reserve Board released its August 2018 Beige Book update, which contains a summary of commentary from Federal Reserve districts. Several Federal Reserve banks in the Midwest expressed concerns about the weakening credit conditions of the agricultural sector.
In view of the current economic challenges posed by “margin compression” in the agricultural industry, what are some best practices for moving forward in farm finance?
- 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, the difference between the tax form Schedule F-reported net income and the accrual adjusted net income can be 50% or more. Is a difference of 50% in the analysis of the profitability of your farm customers good enough for your institution and its board?
- Encourage your customers to pursue opportunities to reduce the costs of their operations. This is critical in the environment of “margin compression” we operate in today. A recent university study indicated this was one of the key attributes of producers generating higher-than-average profits in this economic environment.
- Work with the borrower in projecting cash flow at “long range prices” to determine whether the farm is structured to succeed. Use the annual cash flow projections to complete a sensitivity analysis or stress test 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 customer — and document — the risk management strategy of the business for the coming year, particularly as it relates to insurance, marketing and plans for the reduction of costs as feasible.
- Itemize carryover debt and address with the customer the driving forces behind it, plans for correction, and the optimum means to eliminate it.
- Pay close attention to liquidity. Recent university studies reflect a decreasing trend in this metric overall in Midwest farming operations since 2012.
If your institution is interested in an independent review of your agricultural and commercial loan portfolios, consider contacting Wipfli to provide additional support for your loan review function. Our staff are seasoned professionals, each with over 20 years of experience in the industry.