Klinefelter: By the Numbers

By Danny Klinefelter
DTN Farm Business Adviser

In my last two articles, I looked at what I believe will be the major drivers of change in agriculture over the next decade. This article looks back at four things that stand out to me as reshaping agriculture over the last 10 years.

1. Land Values and Market Value Equity

Farmland values boomed and landowners’ market value net worth increased dramatically. The financial crisis and real estate market collapse in the non-ag sector proved to be just a hiccup in the farmland market. While most of the country has experienced increases in farmland values, I think too many people have generalized the boom that happened in the Corn Belt and surrounding states. The land market surge has been more regionalized in terms of potential for a land bubble.

Lenders played much less of a role in fueling the land market than they did in the late ’70s and early ’80s. At that time, lending decisions were more heavily collateral based and many lenders based collateral values on current sales and were willing to loan more or refinance carry-over debt relying on appreciation equity. Also, lender competition and loan officer incentive programs drove the land market higher than sustainable repayment ability justified. When land values and farm income started to fall, many lenders used the Farmers Home Administration to bail them out by refinancing distressed borrowers and continued business as usual until the market finally collapsed, making the farm financial crisis worse than it would have been had they curtailed lending when profits turned down.

During the recent run up, major lenders such as Farm Credit Services of America and others began establishing their lending limits based on a more sustainable value approach using an earnings and repayment capacity perspective over the projected repayment period. For example, a capitalization rate of 5% and a conservative net return to land of $300/acre would justify a $6,000/acre value with a loan limit of 80% of that amount, even if current cash rents were $400-500/acre and land was selling for $12,000-15,000/acre. The buyer had to come up with the balance or provide additional land as collateral.

Most lenders also recognized that cash basis taxable income is often a very misleading measure of profitability. It has been my observation that timing is one of the major differentiators in terms of separating the best producers from their competitors. The two-to-three-year lag between cash and accrual adjusted income in recognizing downturns or upturns in profitability is often too late to take appropriate action. Couple that with the build-up in deferred taxes that often occurs with cash basis accounting and the problem gets compounded when taxes come due at a time when true profitability isn’t there; e.g., liquidating inventory to cover cash shortfalls. Increases in earned net worth, equal to after-tax, accrual-adjusted net income less withdrawals, are a better indicator of economic viability.

2. Liquidity and Working Capital

True liquidity is the ability of the business to generate sufficient cash to meet financial obligations as they become due without disrupting the ongoing operation of the business. Many lenders and better producers appear to have learned that net working capital-to gross revenue is a more accurate measure of operational liquidity than the commonly used current ratio which is more a measure of structural liquidity and can be very misleading, particularly in a seasonal business. Adequate liquidity analysis also requires considering alternative scenario impacts on projected repayment ability and setting different standards for liquidity levels based on leverage, income/cash-flow variability and the quality of risk management/mitigation.

3. Interest Rates

Low interest rates not only reduced producers’ costs but also gave them the opportunity to lock in rates as a hedge against future increases. This is particularly true right now if they restructured their debt to take more of it out of a fixed rate and were able to improve their liquidity position.

The problem is that many producers apparently believe they can outguess or time the market and opted for shorter amortization periods or adjustable rates in order to save 1%-1.5% on their interest rate rather than looking at the higher rate as a low-cost insurance premium. This is even truer if their loan doesn’t have a prepayment penalty. But time is running out on this strategy, so I don’t recommend further delays if you haven’t fixed rates on real estate debt.

4. Income Cycles

I’m always worried when I hear producers say it’s a new paradigm when agricultural profitability moves to higher levels for an extended period. Unfortunately, I’m afraid we’ve seen too many grain farmers adjust their business strategy based on that assumption.

Remember, the function of a competitive market is to drive the economic return to the average producer to breakeven through supply and demand responses in both input and output markets. As we move toward equilibrium, the top end remains profitable and growing, the average are just hanging in there and the bottom end are losing money and exiting the industry.

Those who get washed out as prices return to more normal levels may be the poorer managers or young producers who got in just before the downturn in profitability. It’s just another way to explain the old saying that "the best cure for high prices is high prices." The high grain prices that created excess profits have driven up input costs, including rents, and pulled new foreign competitors into the market, driving down profits.

There are many more things that can be learned from the recent good times in the grain industry. I would be interested in what you think have been the most important. My email is danklinefelter@tamu.edu.

Editor’s Note: Danny Klinefelter is a professor and extension economist with Texas AgriLIFE Extension and Texas A&M University. He is the former director of The Executive Program for Agricultural Producers (TEPAP), a management short-course for farm producers held each January, and its alumni association, AAPEX. For information on the course and DTN’s TEPAP scholarship program, go to http://tepap.tamu.edu/…