With high crop prices and crop insurance, how can farmers declare bankruptcy? The answer: They didn’t stress test their leverage and did not respond properly to the results.
Leverage can be a nebulous term. If you ask 10 accountants for a definition, you’ll get 10 different answers. To help determine your leverage score, I created a chart. To calculate your leverage ratio, go to each column at the bottom of the page and find your point value. For example, if you own all of your land, your point value is 1. If you don’t own any land, your point value is 4.
Once you have all your point values, add them up for your total score. The minimum score is 4; the maximum is 16. Once you have your score, the following table gives your leverage amount.
Farmers with inherited land and little expansion will score less than 9. Farmers who rent most of their land or own land that was purchased in the last few years will score between 9-12. Farmers who are expanding and borrowing will score more than 12. If your score is 16, you are one small hiccup away from being out of business.
For example, Joe farms 2,000 acres of corn-on-corn in 2012. All of his land was rented with the input costs financed through the bank, which requires 85% coverage with crop insurance.
To save money, Joe did not choose the harvest price option. With average yields of 200 bu. per acre and cash rents at $300 per acre, Joe estimated all-in total production costs of $950 per acre. Based on Joe’s analysis at planting time, he expected per acre revenues of about $1,130 less his farm costs of $950 for a profit of $180 per acre or $360,000. His lifestyle costs were about $120,000 and after paying income taxes of $100,000, he expected to reinvest $140,000 back in the farm.
Drought Hits. Joe harvested 130 bu. per acre. Since he hedged his input costs, he could not take advantage of the run-up in harvest prices. He nets the spring insurance price ($5.65) on all of his bushels. His gross revenue is based on 130 bu. plus 40 insurance bushels for a total revenue of $960 per acre. Joe profited $10 per acre, or $20,000 total; however, his lifestyle cost him $120,000, leaving him out-of-pocket $100,000 on the year.
His high leverage score left him with little liquid working capital to soak up the deficit. This forced the bank to put more restrictions on his loan for 2013, which meant Joe had to reduce rented acres by 500. Due to the large total planted corn acres and trend-line yields, the average price received on his 200 bu. for the year was $5. This resulted in net income to the farmer of $50 per acre or $75,000. However, Joe’s lifestyle costs are still $120,000 plus estimated income taxes of $25,000 puts him in the hole another $70,000.
During the two years, his higher leverage contributed toward negative cash flow of $170,000.
Remember, the most important part of the analysis is not your score, but what you do with it. Review your score each year and if it is higher than you or your banker desires, work on at least one component to reduce your score. A lower score might allow a higher profit with reduced risk.
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at paul.neiffer@CLAconnect.com.