Michigan Farm News

Dollars and Sense: GreenStone FCS

Columnists

GreenStone FCS | November 9, 2017

In today’s challenging economic times, it is more important than ever to monitor the operational efficiency of your operation. Paying close attention to imperative financial information can reveal the financial-health of your farm and identify possible options for improvement.

One of the simplest measurements to assess is your break-even point - when revenue fully covers costs. Most producers inherently sense whether they are breaking even by watching their working capital level and knowing whether they have enough money in the bank to pay all their bills each month.

An assessment of costs and revenues will provide deeper insight. When the data shows that break-even is not being met, the producer understands the need to reduce costs or increase revenues for the operation to be viable long-term.

Comparing your data to prior performance as well as industry benchmarks also provides great insight. On dairies, for example, this typically means analyzing three- to five-year trends in earnings, feed costs and labor costs, typically by hundredweight or cow.

To compare performance with industry standards, multiple resources exist, such as the peer comparison information GreenStone Farm Credit Services has compiled, several accountancies provide relevant regional data across a broad number of producers, and universities also offer benchmarking data.

It is important to be mindful when comparing your operation to others that the type of operation and its associated costs can vary greatly. For example, a dairy that buys feed and replacement cows will have a different cost structure than one that raises its own replacement cows and has ample pastureland. A grain producer who rents land will have different costs than one who has purchased land. A larger operation of any type likely benefits from economies of scale, particularly regarding labor costs per unit.

Another means to measure operational efficiency is analyzing your profit and loss (P&L) statement with accrual adjustment, which shows the sources of income and operating expenses.

Comparing P&L statements over time reveals how the operation is trending, as does analyzing several large expense categories in proportion to revenues.  If you run a dairy operation, for example, feed purchases should total no more than one-third of revenue and labor no more than 10 percent of total revenue. For grain and similar cash-crop operations, no more than 25 percent of revenue should go to inputs such as seed and chemicals.

At a deeper analytical level, a series of key financial ratios offers significant insight. These ratios offer an objective assessment of an operation’s performance at a given point in time:

  1. Working capital, the difference between current assets and current liabilities, is the main measurement of liquidity. Producers should seek a 2:1 ratio of assets to liabilities.
  2. Working capital over revenue is another liquidity ratio, often with a goal of holding one-third of farm production value as current assets. If this level is not being achieved, the producer should find ways to increase inventories and reduce current liabilities, perhaps by working with a financing partner to consider options such as restructuring debt to stretch payments over a longer time.
  3. Equity-to-asset ratio is a solvency ratio, which measures how much equity, or net worth, a producer has in relation to assets. For every $100 in assets, an operation should have $50 in equity or 50 percent. A lower ratio often indicates the assets are borrowed against, and producers in this situation should likely focus on repaying debt or liquidating assets.
  4. Rate of return on farm assets measures your operation’s profitability, which should be at least at or above the interest rate earned on a typical savings account. In today’s low-interest rate environment, any rate greater than 4 percent is positive for the producer. If the percentage is less than this, the producer should focus on generating more profitability by increasing margins or selling off non-performing assets and either paying down debt or investing in assets that will generate more profitability.
  5. Rate of return on farm equity is another profitability measure and is more common for producers seeking investors into their operation. It can also provide decision-making support – if this rate is lower than desired, again the solution is to increase the profit margin and/or reduce the debt load.
  6. Asset turnover ratio is one way to measure financial efficiency by measuring an asset’s ability to generate revenue. While the ideal is a 1:1 ratio in an asset’s first year, (meaning that every dollar invested in an asset generates a dollar in revenue) it is extremely rare in agriculture. A more realistic target for producers is a 30-cent or 40-cent return on each dollar invested; operational decisions such as renting land rather than purchasing it as an asset can improve this ratio if needed.
  7. Operating expense ratio demonstrates operating expenses in relation to the revenue generated. If, for example, an operation generates $100 in revenue and only spends $10 on operating expenses, it has a 90 percent operating efficiency. For agriculture, a level of 65 – 75 percent is acceptable. If an operation’s ratio is not at this favorable level, the first solution is to reduce operating expenses, but if costs have been cut as far as possible, working to generate more revenue at the same cost level will be key, either by increasing productivity, marketing for a better price or selling more units.
  8. Repayment capacity is a critical measurement for lenders, as it conveys a borrower’s ability to repay their loans. Typically, a 1:1 ratio is acceptable, meaning that the producer is generating exactly enough revenue to repay their debts; however, a better goal is ratio of 1.15 – 1.25, which indicates that the producer is generating excess revenue that can be added to working capital or invested in strong performing assets.

Reviewing your critical financial data is an ongoing responsibility for sound operational management. Look for a financial partner who will sit down with you on a quarterly, or even monthly basis, depending on your operation, to drill down on the relevant data points.



Columnists

GreenStone FCS | September 7, 2017

Martin Karperski

 

Farming is a capital-intensive business, with land, equipment and facilities that can run into millions of dollars.

Beyond these capital expenses, farmers face annual input costs for seed, fuel, chemicals, etc. These inputs are often needed at the beginning of the growing season and paid for with proceeds from the sale of crops months in the future. To bridge this gap, many farmers utilize an operating loan, which is a revolving line of credit for the farm.

These loans are tied to the production or operating cycle: money loaned at the beginning of the season is expected to be used for the essential inputs needed to raise that season’s crop, and then paid back at the end of the cycle with the proceeds from the crop or product that was produced using the inputs purchased. This is different from term loans, because those are tied to the productive life of the asset being financed, such as up to seven years for equipment or up to 30 years for real estate loans.

Often, using operating funds provides producers access to early-season or pre-paid discounts. For example, reduced prices on seed if purchased in December for a crop that will not be planted until April.

In the current economic environment, higher input costs, along with lower crop prices, have led to lower levels of working capital. As a result, operating loans have become more prevalent even among the most financially sound farmers who may have traditionally paid for inputs with available working capital.

Many farmers employ the revolving line of credit at the beginning of the production cycle, then pay it off at the end of the productive season using the profits from the sale of their crops or products, and then start the process again for the following season.

Using an operating loan, money is drawn as needed and interest begins accruing only as funds are pulled from the credit line.

Operating loans are not commonly used to finance capital investments because of the short-term nature of the loan. Short-term financing for a long-term asset can cause repayment challenges, which is why farmers more commonly match their financing to the useful life of the asset.

Typically, the security for operating loans is the chattel, a word used for shorter-term farm collateral, which can include the crop, both growing and stored, as well as machinery and equipment. Occasionally, a farmer will prefer to use real estate as collateral for an operating loan, such as in scenarios when the crop itself is jointly owned, or there is a prior lien holder on the crop. Security for the operating loan is primarily the borrower’s decision based on the operation’s unique situation. However, when the crop is used as the collateral, in some cases the lender may also require crop insurance, with an assignment of indemnity on the policy.

One of the risks of employing an operating loan is when the crop does not yield enough return to pay off the loan, such as when prices drop unexpectedly or poor yields. In this type of situation, the farmer may be forced to carry the operating losses into the following crop cycle if they do not have alternative capital available to cover the balance.

As farmers know, the continuation of this situation impedes profitability and the accumulation of working capital, and increases financial risk.

Operating loans are common across industries, from dairies to cash crops, fruit orchards to vegetables, nurseries to greenhouses. When used properly, they provide financial liquidity when it is needed most, with a short-term repayment to be able to efficiently remove this debt from the balance sheet.

Martin Kasperski, Senior Financial Services Officer, GreenStone Farm Credit Services

Columnists

GreenStone FCS | June 6, 2017

Ben Spitzley

 

 

By Benjamin Spitzley, Vice President and Commercial Lending Group Manager, GreenStone Farm Credit Services

The dairy industry is facing a challenging time, a cyclical downturn that’s lasted longer than in previous cycles, and is expected to continue for at least the near-term. The predominant factor behind the current status is simple market mechanics: there is an abundance of supply relative to demand.

This situation arose from increased demand in the years leading up to 2014, which raised prices and encouraged dairy operators to expand their herds to increase production. In Michigan, for example, the dairy industry has grown by 72 percent since 2004, and the industry added 12,000 cows in 2016 alone, a year when the average producer was losing money.

Nationally, the USDA reports that herd size is continuing to increase, despite the lack of profitability, from 9,328,000 cows in 2016 to 9,385,000 in 2017. While supply has increased, and continues to increase, demand has not kept pace, creating a surplus of milk in the market.

There is also a glut in the global market as other nations increased their production to meet demand; combined with the strengthening of the U.S. dollar and trade uncertainty, there has been reduced demand for U.S. dairy exports, which traditionally represented 15 percent of our nation’s dairy production.

Exacerbating the situation in Michigan is a dearth of processing capacity, which has not increased in line with milk production. This puts producers in the unenviable position of needing to market their milk out-of-state, where processing is available, adding transportation costs and additional marketing costs to their already challenged cash flows.

The erosion of revenue is significant. In 2004, Michigan’s dairy farmers were being paid 25 cents more than the U.S. average per hundredweight; last year, they were paid $1 less than the national average. Adding processing capacity will be paramount to protecting dairy producers against these additional costs.

Over time, the market will balance itself out, as supply and demand draw closer together and processing capacity is added. In the meantime, producers need to take a hard look at their operations and their financials. Producing a high quality product with good components will support a better price and better marketing options.

Producers should strive to tighten overhead with a careful eye to reducing costs and streamlining operations. Every asset should be examined to determine if it is producing enough revenue to justify keeping it – whether the asset be surplus heifers, or a two-year inventory of feed.

In short, if you cannot afford the asset, scale it back or sell it off. Any capital investment needs to be carefully scrutinized, with a complete Return on Investment (ROI) analysis to ensure it will add to the bottom line.

It is also critical to maintain good records to support effective management decisions. These will help producers manage their working capital, identify potential cost savings, and know whether they have the resources to take advantage of opportunities when they arise.

Also supporting effective decision making is an advisory team, on which producers should include key employees, vendors and financial advisors. This team should be tasked with helping to proactively develop not only a plan, but also a backup plan, for managing through this cyclical downturn.

Such plans will need to be individualized for each operator, and may include steps like finding additional sources of income, implementing specific cost-savings solutions, or changing the overall scale or scope of the business.

Lenders, like GreenStone Farm Credit Services, will strive to find methods, such as interest-only solutions or increased access to operating funds, to support customers who can demonstrate they have thought through their specific situations and have developed a plan for moving things in the right direction.

Looking forward, there are bright spots on the horizon. It is anticipated that milk prices will begin to rebound by the fourth quarter of 2017, though the increase is expected to be modest given the processing dilemma.

Producers who manage to reduce their costs and streamline their operations during this period of belt-tightening will be optimally placed to benefit from any improvements in the market. And, there will continue to be a demand for milk; the Great Lakes region, with its abundant forage and water supply, will remain an ideal location to produce milk for the benefit of a growing world population.

 

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Columns

Measuring operational efficiencies

Dollars and Sense

GreenStone FCS | November 9, 2017 

In today’s challenging economic times, it is more important than ever to monitor the operational efficiency of your operation.
 

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Understanding operating loans

Dollars and Sense

GreenStone FCS | September 7, 2017 

Martin KarperskiFarming is a capital-intensive business, with land, equipment and facilities that can run into millions of dollars.
 

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Dairy: an unenviable position

Dollars and Sense

GreenStone FCS | June 6, 2017 

Ben SpitzleyThe dairy industry is facing a challenging time, a cyclical downturn that’s lasted longer than in previous cycles, and is expected to continue for at least the near-term.