Stress testing of your financial projections involves a range of techniques that can be used to assess the vulnerability of a farm’s balance sheet, cash flow and repayment capacity to changes in revenue and costs. Stress testing can be an extremely useful tool to examine strategies for dealing with lower prices, higher costs, lower government payments, asset purchases and changes in loan terms.
In this article, a case farm in west-central Indiana is used to examine the impact of different yield scenarios on key financial ratios. The case farm has 3,000 acres of corn and soybeans, with 2,250 acres rented and 750 acres owned.
In 2018, net farm income was about $78 per acre. Government payments were about $52 per acre. Corn and soybean yields were 8% and 9% above trend yields, respectively. Above-trend yields added about $53 per acre to net farm income.
Now let’s look at projections for 2019. Using trend yields, lower government payments, higher fertilizer costs and projected prices give a projected net farm income in 2019 of negative $23 per acre, or $101 per acre lower than actual net farm income in 2018. If yields were 10% higher than trend for both corn and soybeans, net farm income would increase to $36 per acre. Notice that even with above-trend yields, net farm income would still be lower than that experienced in 2018.
In addition to examining the impact of changes in revenue and costs on net farm income per acre, it’s useful to examine the impact of these changes to the farm’s operating profit margin ratio and repayment capacity. Under the base and above-average yield scenarios in 2019, the operating profit margin ratio is negative 0.037 and 0.057, respectively. Under the base scenario, this farm would have to use liquidity to cover operator labor.
One of the most useful repayment capacity measures is the capital debt repayment margin, which is computed by subtracting interest and principal on term debt, income and social security taxes plus operator labor from the sum of net farm income, off-farm income and depreciation.
Debt repayment margin
A positive capital debt repayment margin signifies that the farm has sufficient funds to cover principal and interest payments on debt related to machinery, building or land loans. Under the base and above-average yield scenarios in 2019, the capital debt repayment margin is -$35,650 and $143,063, respectively.
Again, under the base scenario, this farm would have to use liquidity to help cover principal and interest payments on term debt.
As noted, stress testing can be used to examine the sensitivity of profit and repayment capacity to changes in revenue and costs. Given the current uncertainty in prices, stress testing is particularly important this year. Stress testing can be a very important tool in the development of contingency plans.
Specifically, use it to answer the following questions: How is our farm going to cover principal and interest payments if net returns are relatively low in 2019? Do we have enough liquidity to cover potential losses, or we will need to consider taking on more noncurrent debt or selling assets?
Langemeier is a Purdue University Extension agricultural economist and associate director of the Purdue Center for Commercial Agriculture. He writes from West Lafayette, Ind.