Instead, test farm financials to answer what-if questions
The past few years have been tough on farmers. Although nobody has a magic eight ball, there’s one way farmers can have a good idea of what could happen in the future: stress testing.
Similar to the tests cardiologists perform if they suspect a patient has a heart problem, stress testing your financials puts some real numbers behind what-if scenarios, veteran banker Ashley Arrington says.
“A lot of farmers have suffered losses, and some have had to make tough decisions,” says Arrington, CEO of Agri Authority, a consulting firm. “Stress testing gives them the parameters for that situation. If
they need to make those potentially tough decisions, they’ll know what their boundaries are.”
Value Proposition. Stress testing can be an important tool in evaluating how to deal with lower prices, higher costs or changes in loan terms, says Michael Langemeier, ag economist at Purdue University’s Center for Commercial Agriculture.
“Lenders want to have an idea how long an operation’s borrowing base margin can sustain a given negative cash flow,” adds Arthur Moessner, vice president of agribusiness for Farm Credit Services of America. “In other words, at what point does the operation run out of its capacity to borrow?”
To stress test revenue, Arrington suggests analyzing income. She tells the story of a producer in Ohio who had 10 straight years of great yields and revenue. Then, for two straight years, weather events created serious problems that drained her working capital. The producer and Arrington needed to know what would happen if the operation suffered another year of unfavorable weather. “We hope it doesn’t happen,” she says. “We’re going to say our prayers and cross our fingers. But we need to know.”
Plan Ahead. Farmers should stress test their financials yearly, says Vince Bailey of Farm Credit Mid-America.
“You need to have a plan,” Bailey says. “Hope is not a plan.”
It’s a good idea to do this type of analysis in December, around the same time farmers prepare for income taxes. “One of the common issues we see is that 100% of your earnings will go on your balance sheet, but not all of your costs will go on your tax return,” he says.
Also assess equity position. Take your financial statements and your most recent balance sheet, and adjust the land value down 20% or 30% until you find the pinch point. “How much can you stand before you’re really going to have a breakdown?” Arrington asks.
Financial Terms to Know
When discussing a stress test with your banker or other financial advisers, there are a few concepts you need to understand.
Borrowing Base Margin: The net amount of funds your lender will allow you to borrow based on a formula set on collateral.
Cash-Flow Burn: This helps lenders quantify a business’s ability to handle financial stress. The available burn is the amount of borrowing base margin that can be used to fund losses.
Equity: This represents the difference between the value and the liabilities of assets you own.