By Bernt Nelson American Farm Bureau Federation
Most farms in the United States are small family-owned businesses that rely on the availability of finance options to find the large cost of producing the food, fiber and renewable energy our country and the world rely on every day.
American Farm Bureau Federation
According to the U.S. Department of Agriculture’s 2017 Ag Census, about 97 percent of the 2.1 million farms in the United States are considered family farms. And 88 percent of all U.S. farms have a gross cash farm income of less than $350,000 annually, putting them in the small-family-farm category. That means most farms in the United States are small family-owned businesses that rely on the availability of finance options to fund the large cost of producing the food, fiber and renewable energy our country and the world rely on every day.
According to the USDA’s most recent Farm Sector Income Forecast, interest as an expense increased by about 43 percent or $10.3 billion, to $34.42 billion in 2023. Interest-rate increases have not only increased the cost of credit as an input but have also limited farmer ability to use it. This Market Intel will give readers a glimpse of the farmer-credit world and explain how changes in that environment could lead to challenges with liquidity – a problem that’s difficult to fix.
Liquidity important to farms
An extremely important part of farm finances, farm liquidity is “the ability of a farmer to generate cash quickly and efficiently in order to meet his or her financial obligations.” Some assets such as corn in storage can be sold and turned into cash quickly; they’re considered assets with excellent liquidity. Others such as a crop that was recently planted or livestock that have not yet been born, take more time to turn into cash. They can require additional input expenses to become the final product for sale, such as grain or marketable livestock. When farms become tight on cash due to the extreme cost of operating or from overspending, lack of liquidity can become a real problem.
According to the 2023 Ag Lenders Survey conducted by the American Bankers Association in partnership with Farmer Mac, liquidity was farm lenders’ most important concern in 2023 – followed by farm income. Lenders listed increasing interest rates as the No. 1 reason for liquidity concerns.
Liquidity measured with ratios
Liquidity is measured using several different accounting ratios. Before diving into the different ratios, it’s important to first understand working capital. Working capital is not a ratio; it’s a measure in dollars of total assets minus total liabilities. That’s a measure of available cash. When evaluating this measure the question often asked is, “How much working capital does a farm need?” Working capital needs are greatly variable by farm size, exposure to risk and volatility of the overall business environment. When net returns are more variable, more working capital is needed. Due to those differences, it’s helpful to measure working capital by either gross revenue or value of farm production.
One of the most used liquidity ratios is the current ratio. The current ratio – sometimes called the “working capital” ratio – measures a business or farm ability to pay off debt due within one year. It’s the ratio of current assets divided by current liabilities due within one year. A current ratio of 2 or more is considered good. Anything less than 2 is cause for concern.
The debt-service ratio, sometimes called the term-debt-coverage ratio, measures a farm’s ability to use operating cash flow to pay debt obligations. Lenders typically like this ratio to be 1.5 or greater. A ratio of 1 would mean the farm has adequate cash flow to meet payment obligations. A ratio less than 1 would mean the farm will need to rely on other resources to service debt.
As previously addressed, it’s helpful to evaluate working-capital needs in comparison to gross revenue or value of farm production. The working-capital-gross-revenue ratio is a measure of whether or not a farm has adequate working capital for its level of gross revenue.
- A farm with a ratio of 30 percent or greater is considered strong.
- A ratio of 10 percent to 30 percent is cause for concern.
- A ratio of less than 10 percent is considered vulnerable.
For example, a farm that has a ratio of less than 10 percent will rely heavily on borrowed money to operate because they will run out of their own money early in the year. A farm with a ratio more than 30 percent will rely on borrowed money, but not as heavily and not as quickly.
One ratio that has not been widely used since the 1980s is the interest-expense ratio. This ratio shows how much gross income is being used to pay interest on debt. In years when interest rates are reduced, this ratio may be overlooked because it remains well within healthy parameters. But when interest rates increase, the interest-expense ratio can be a stark reminder that taking on unnecessary debt or too much debt can be costly. When more capital is being used to pay for interest, it means less capital is being paid toward equity-building principal. Figure 2 illustrates the ratio of total U.S. ag-sector interest expense to total U.S. ag-sector cash receipts. Note the 2.25 percent increase in this ratio from 2022 to 2023, the largest year-over-year increase since 1981.
Farmers face liquidity problems
Farmers have many recurring annual costs such as land rent, input expenses and debt payments. A farm with strong liquidity has cash available to pay those recurring costs and potentially pay for growth such as new land or equipment purchases.
Problems with liquidity can come from changes in the financial environment. For example when costs of inputs such as fertilizer, seed and fuel increase, it takes a greater amount of working capital to pay for them. That means working capital is depleted faster, potentially limiting a farmer’s ability to meet cash-flow needs.
When working capital is depleted, farmers have a variety of options to help liquidity. Selling cash assets such as crops in storage may be an option but may be costly if market conditions are not favorable. One of the most common solutions to liquidity is through a variety of credit-based solutions such as operating loans. Credit-type solutions can be a great option but they can be expensive and endanger the long-term sustainability of a farm if relied on too heavily when interest rates are inflated. Liquidity problems of that nature can turn into a cycle that’s increasingly difficult to break for the farmer.
Consider U.S. farm-sector debt
U.S. farm-sector liquidity has been good and strengthening since 2020. But the recent decrease in ad hoc government assistance combined with Federal Reserve-driven interest-rate increases and increasing operating costs have changed the financial environment. According to the USDA-Economic Research Service’s Agricultural Resource Management Survey, about 23 percent of U.S. farms carried some form of debt in 2022; that’s a 4 percent decrease from 28 percent in 2018. The data provides a general feel for farms carrying debt through 2022 but it doesn’t capture which farms are carrying debt. So even though the percentage of farms carrying debt has decreased, it’s not necessarily an indication of a healthier farm economy.
U.S. Farm Sector Financial Ratios are calculated using national aggregate data, which is different than national average data. The data used in these calculations comes from farms that carry debt. But not all farms carry debt so it’s not fair to say these liquidity ratios are a measure of the average U.S. farm.
A good current ratio is more than 2. According to the U.S. Farm Sector Financial Ratios published by the Economic Research Service, the U.S. ag sector had a current ratio of less than 2 from 2015 through 2021. That ratio has remained at more than 2 since 2021 but is forecast to decrease from 2.15 in 2022 to 2.09 for 2023 – at about the threshold for caution.
The debt-servicing ratio used by the Economic Research Service is a modified version of the term-debt-coverage ratio. The USDA uses that ratio to measure the share of production plus direct government payments that are used to pay off farm-sector debt. A greater debt-servicing ratio implies that a greater share of production is needed to pay off debts, and thus less liquidity in the farm sector. The Economic Research Service forecasts the ratio to increase from .21 in 2022 to .24 in 2023. A greater cost of debt from sustained inflated interest rates could lead to continued debt-servicing-ratio growth in 2024. For comparison, the debt-service ratio reached a record level of .46 in 1983. That means that 46 percent of all farm-sector production and government subsidies were used to pay for farm debt.
Farmers have tools to help
Management – One of a farmer’s greatest financial resources can be a lender. Loan officers are more than just faces at lending institutions. They become friends and advisers in addition to financial-service providers. Helping farmers avoid problems with liquidity is typically in the lender’s best interest as well as the farmer’s so it’s important they work together. When problems happen with liquidity, operating loans can be a go-to solution. Operating loans can be refinanced to adjust for operating-cash needs. But it’s important to note that refinancing costs money in the long run. And every time a refinance occurs, there are fewer options available the next time around. Refinances can become a danger zone if used improperly. That’s why a relationship between a farmer and lender is so important.
Farm-operating loans and revolving lines of credit are an essential tool to help farmers manage day-to-day expenses. They are available through federal programs such as the USDA-Farm Service Agency’s Direct Farm Operating Loans or through commercial ag lenders. These loans are designed to provide financing for the cost of operating a farm and can help provide much-needed liquidity when capital is tight. Operating loans can be used for a variety of purposes including supply costs, repairs, land development, and livestock and equipment purchases. The terms of repayment vary but operating loans are typically renewed on an annual basis.
The FSA’s commodity loans such as marketing assistance loans and loan-deficiency payments can help mitigate liquidity problems. Both tools can offer financial support to farmers at and after harvest.
Marketing-assistance loan – A marketing-assistance loan is a nine-month loan that provides producers with interim financing at the time of harvest to meet cash-flow needs without needing to sell their commodity under current market conditions. There are two types of loans – recourse and non-recourse. During the life of the loan, farmers are allowed to store the covered commodity so they can sell it when market conditions hopefully improve. Under non-recourse loans, the USDA must accept the commodity – pledged as collateral – as payment. A recourse loan must be repaid in full as principal and interest. These loans are valued using county-level commodity-specific loan rates established by the 2018 farm bill. For non-recourse loans, if local prices increase to more than the loan rate, the farmer may repay the loan and keep the pledged commodity. If local prices decrease to less than the loan rate, the farmer can repay the loan at the reduced market price or surrender the pledged commodity in lieu of repayment. The farmer would then receive the difference between the reduced market price and the marketing-assistance-loan rate.
Loan-deficiency payments – Loan-deficiency-payment provisions specify that a farmer, though eligible for a non-recourse marketing-assistance loan, may choose to receive loan-deficiency payments instead. The payment is equal to the loan-deficiency-payment rate times the quantity that is eligible for a loan. A loan-deficiency payment is triggered when the posted county price decreased to less than the county-loan rate. A loan-deficiency payment is the difference the producer would have received if a loan was repaid at the reduced market price, a direct benefit that does not need to be repaid. The farmer may then store or market the covered crop however she or he chooses.
Term loans also solution
One more solution available for farmers when capital is depleted and liquidity is an issue is a term loan. Agricultural term loans are long-term loans that are used to finance investments and operations. These loans are collateralized and are different than an annually renewed operating loan. Using a term loan for short-term needs is often a last resort because it’s expensive when interest rates are at record extremes, and is not an indicator of good financial health.
Ag-sector liquidity has been strong in recent years but the financial environment has changed and inflated interest rates are adding another expense to a farmer’s lists of increasing input costs. Operating loans and other forms of financing cost farmers a whopping 43 percent more in 2023 than in 2022. They are forecast to remain inflated for much of 2024, causing working-capital stocks to decrease faster and forcing farmers to lean on expensive credit to provide liquidity. When farmers pay more for interest on that credit, less money is paid toward principal. The amount of income being used to pay interest on farm debt in the United States has increased at a rate not seen since the 1980s. There are many tools available to help farmers persevere when liquidity makes their businesses vulnerable, but it’s important for decision makers to remember a lesson from the 1980s. Short-term borrowing during times of vulnerability can turn into costly long-term debt. Excellent management and decision-making are a must to remain resilient during times of vulnerability.
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