How your farm numbers can guide you in your dreams
Many years ago I worked under the late Andy Sirski at Seednews. He taught me how to explain out loud how something worked before I wrote about it, how to write an interesting headline, and the difference between wondering and thinking. “Asking gets you nowhere,” he said.
Invariably, these tools helped me focus and move on or give up on an idea that had too many holes in it. And it’s the same thing to have numbers in front of me. It always gives me the confidence to plan.
Knowing what is going on internally with your farm’s finances should give you peace of mind, especially in times of amplified change like we are currently experiencing. Stopping first and understanding your position eliminates knee-jerk reactions and generally leads to better conversations with your lenders. Not only is it important to know the financial situation of your farm today, but also how it has evolved over the years and how it compares to similar farms.
A few key performance indicators can help you know which areas of your farm would benefit the most from a change. Then you can start analyzing what-if scenarios with confidence, fill out grant forms, get quotes, and contact your lenders.
When considering changes, Mark Verwey, BDO’s national agricultural industry manager based in Portage-la-Prairie, Man., says farmers can start thinking about an opportunity by using their financials to calculate a few ratios. . “Three key ratios – working capital, debt service and debt ratios – can strengthen your decision-making and subsequent negotiations,” he says.
The working capital ratio lets you know if your farm has the resources to meet its financial obligations for the current year. The working capital ratio is current assets divided by current liabilities, with these numbers taken directly from your balance sheet. It is current, short term and focused on a production cycle and gives you an idea of what is available to make an investment.
It’s a ratio you need to meet and know what your banker considers a threshold, says Verwey. “If you notice a problem with your working capital, it’s a short-term issue that can be resolved, often with a conversation with your banker,” he says. “Some solutions such as selling long-term assets, balloon or bridge financing, or even reducing or extending your debt repayments might be needed in the short term to help you get through tough times.”
Another important ratio to look at is the debt service ratio which tells you if the farm can generate enough cash flow to meet its annual debt obligations. Basically, the debt service ratio compares cash earnings before interest and principal payments to your interest and principal payments that are due the following year. Typically, lenders like to see a farm’s cash profits exceed cash obligations by a factor of 1.25 for grain and oilseed producers. Be aware, however, that different lenders may calculate this ratio differently and different sectors have different thresholds, such as grain and oilseed producers versus dairy farms.
“Some producers trying to pay off their debt quickly may show vulnerability in the debt service ratio during difficult production or marketing periods,” says Verwey. “Leave room for a few storms.”
Another ratio that can help you focus your thinking on growth is the debt ratio. It can tell you (and your lender) if the farm has enough collateral to cover debt, including short-term and long-term debt. It also tells lenders how much skin you have in play versus how much they have in play.
Debt and asset figures usually come directly from your farm’s financial statements and will therefore be based on the book value of your assets. It’s also useful to calculate this using the fair market value of the assets, and it’s important to look at this over the years. If this ratio is steadily declining, you may need to consider selling productive assets like land or quota.
Comparing these ratios to what they would look like after expanding/making other investments will help you move from questioning to thinking about an investment. Plus, having these numbers handy when trying to get an investment loan will help you prepare for some questions.
With these three ratios in hand, you can begin to assess your operational financial state and think about potential changes that will improve profitability. Ask yourself what are the most important decisions you need to make to ensure the success/profitability of your operation? For grain and oilseed farms, the contribution/commodity margin can be informative. For farms under supply management, direct cost control decisions have a greater impact. Therefore, knowing your gross margins/kg for each company can have an impact. By looking at gross margin and contribution ratios over time (at least five years), you can start to see some trends and gaps.
Before spending the winter dreaming of a new barn or filling out grant forms for a heat exchanger, start by knowing these ratios for your farm. It will give you a solid starting point, help you set up your agricultural investments for success, and most importantly, take you from wonder to thought.