During the 1980’s farm financial crisis the level of farm debt, as measured by the debt to asset, equity to asset, or debt to equity ratios, was a telltale sign of financial difficulties. Agricultural lenders would often cringe when the debt to asset ratio on a market value balance sheet exceeded 50 percent in that era. Of course, this equates to an equity to asset ratio of less than 50 percent and a debt to equity ratio above 1:1.
Given that context, what level of debt creates concern in today's economic environment of low margins and high economic volatility? I had the privilege of working with the FINPACK team at the University of Minnesota at an agricultural lender conference. These lenders were from coast-to-coast and represented all segments of the lending industry. With the use of anonymous clicker response technology, one of the FINPACK team members, was able to enumerate responses. Specifically, the lenders were asked at what debt to asset ratio they were finding the most financial issues.
Not surprisingly, only one percent of respondents indicated that financial issues were present when the debt to asset ratio was less than 30 percent, and only six percent of respondents indicated seeing issues when the debt to asset ratio was between 31 and 50 percent. Forty-one percent of the lenders stated that they found the most financial issues when the debt to asset ratio was between 51 and 66 percent, while another 46 percent responded between 67 and 80 percent. Only six percent of the lenders indicated that the most financial issues were found when the debt to asset ratio was greater than 80 percent.
In commenting on these results, often young and beginning farmers and ranchers, producers expanding their operation, or producers leasing land or other assets will generally have higher financial leverage. If not backed up with sufficient working capital resources to handle adverse situations, the debt service requirements of highly leveraged operations can lead to financial issues.
Next, poor business management in areas such as finance, marketing, and operational inefficiencies combined with high leverage is a recipe for financial issues. During the great commodity super cycle these limitations were often masked by higher commodity prices. In the down economic cycle, such as the past six years, these factors exponentially become worse.
Contrary to the lender survey, I have actually observed more financial issues with higher equity producers or those with a debt to asset ratio less than 40 percent. However, these producers are able to use their land equity as a bridge across the chasms of cash flow, liquidity, and profit issues. Essentially, they are using land equity to lengthen the payment terms of short-term debt. However, in the long run this practice will catch up to them if land values start to decline or if they did not implement corrective action.
Financial leverage is still on the radar screen, but other factors such as cash flow, profits, working capital, and liquidity are becoming more prominent as we go through the decade of the 2020s.
Source: Dr. David Kohl, which is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.