“We’re trying to squeeze the last juice out of some of this iron,” quips Philo, Ill., farmer Steve Hettinger, as we sit in his farm office discussing equipment, one of the biggest expenses on this 7,500-acre grain farm. “We’re repairing a 10-year old planter. We have tractors with 5,000 hours on them; we have eight-year-old combines and just go through and rebuild them each fall.”
Like so many farmers Hettinger and his partner-brother David have been running machines far longer than they would like. But with poor prices and thin margins the past several years, they are skittish about depleting working capital.
Now, with recent rallies that pushed corn past $4 and soybeans past $10, will those purse strings open?
Repair or replace
Steve and David have been mulling that question for some time now. They use Illinois Farm Business Farm Management, a cooperative educational-service program designed to assist farmers with management decision-making, to “keep me disciplined on my books,” Steve says. With FBFM “We can pick out similar farms of our size and compare production and fixed costs.”
What he’s learned from the benchmarking is that the farm’s seed costs are low compared to like-sized farms – mainly because Hettinger is a seed dealer - but their equipment costs are high, mainly due to older equipment that needs more frequent repairs.
“It’s always a balancing act between, putting too many repairs into a piece of equipment that is losing value, or technology changing, verses if I can cash flow a new piece of equipment with current and projected income,” says Steve Hettinger. “We thoroughly study the return on Investment when we purchase new, and how we can cash flow a new purchase and maintain working capital at proper levels.
“With current interest rate levels, ‘new’ looks pretty attractive if the ROI is there.”
Here are seven factors to consider before you pull the trigger on equipment upgrades:
Predicting future farm income – Net farm income for many farms will be higher in 2020 than previous years, due to ad hoc government payments and a surprising recent jump in grain prices. Farmers had a lot of unsold grain so they – hopefully – took advantage of those higher prices.
As a result you could see some tax advantages if you spend that money in 2020, notes Kelvin Leibold, Farm and Ag Business Management Specialist at Iowa State.
Unless you’re paying cash for that shiny new machine, you’ll need to consider what future income streams look like - income that may include much less government support. If revenue must come mainly from the marketplace, what will that look like?
Assess your team’s mechanical ability - Hettinger’s other brother Ray, who is retired, is a talented mechanic, and the farm has several employees who are also quite capable. Not every farm has that skill set, so this could be a factor in ‘new vs. used.’
“We’re probably putting $15,000 into the cost to rebuild each piece of used equipment each year, but that still looks good compared to a half million for a new combine and bean head,” says Hettinger.
For Hettinger, “there’s always something unexpected coming up,” using worn equipment to cover 7,500 acres. “You sometimes feel you’re rolling the roulette wheel, but it’s worked for us so far.”
Change in tax law - Tax rules on trading equipment changed a couple of years ago. You need to understand how it works on Schedule F (Profit or Loss from farming) and Form 4797 (Sales of Business Property). Some farmers who traded equipment recently were surprised to see that they had little or no income on Schedule F, but showed large incomes on Form 4797. It impacts your social security tax and potential PPP (Paycheck Protection Program) payments.
If you have, for example, a combine valued at $100,000 and trade for a $300,000 machine, you have $200,000 of cash or ‘boot’ (money you kick in). In the old days you probably looked at your depreciation schedule, called it section 179 and wrote off the whole amount, driving Schedule F income down $200,000. Under today’s laws if you do this deal you will report the trade-in value ($100,000) as the sales price on Form 4797 and show the purchase of $300,000 machine on Section 179.
“Your total income didn’t change but which form it got reported on changed,” explains Leibold. “You may have ended up showing a loss on Schedule F, which may disqualify you from getting a PPP payment. But it also drove down your social security tax, which is payable off Schedule F profits, not off Schedule 4797. (More on how the tax law impacts equipment trades here and here.)
How much working capital should you maintain? Working capital is the difference between current assets and current liabilities. A working capital ratio, sometimes called ‘current ratio,’ is calculated by dividing total current assets by total current liabilities. The current ratio is a measure of your farm’s liquidity – your ability to pay short-term loan obligations. The higher the ratio, the better.
Some Iowa data shows, on average, a recent 6-year decline in working capital and current ratios. However, the top one-sixth of Iowa farms have actually increased working capital and at least held current ratios constant. Those operations may be in the best position financially to upgrade equipment.
“The decline in working capital and current ratios is a real concern for lenders,” says Leibold. “They want to see positive cash flows without restructuring debt.”
Match fleet horsepower with acreage
Another reason to upgrade equipment is if you’re covering more acres with the same horsepower you had five years ago. Larger, newer equipment may cover more acres faster and with more efficiency.
“If you need more or larger equipment to match farm growth that may be the reason for increased investment,” says Leibold. “If you are not profitable getting larger may not help!”
Another factor to consider: weather extremes. Changing weather patterns may reduce the available days suitable for spring or fall fieldwork.
“When we had really wet springs being over equipped was not necessarily a bad thing, but it’s a balancing act,” notes Leibold.
Buy, lease or roll?
Some farms may be sitting on a lot of cash earning a whopping 1% in the bank. You could take on debt at 5% to own new equipment. You might be able to roll that combine in a highly leveraged trade if those programs still exist. Or, you could lease or get into a ‘lease-to-own’ program.
You need to calculate your opportunity cost of capital; That gets used to calculate ownership costs. Start with estimating operating costs such as fuel, repairs, maintenance and labor, then estimate fixed costs such as actual (not tax) depreciation, the opportunity cost of money, insurance, housing and taxes if any.
To make a good decision, farmers not only need to know costs to maintain and repair older equipment; they also need to know current values of the used equipment they own. They also need to know the cost of breakdowns at crucial planting or harvest periods.
“With older equipment we ask, will it run, and what’s it worth if I trade it?” says Hettinger. “After four or five years, we don’t know that cost. So it costs something even when we don’t spend for new.”
The key is knowing the ownership cost on the old piece of equipment, compared to the new piece of equipment, adds Leibold.
Bells and whistles – If the numbers don’t work in your favor and you still want to justify a new purchase, well, there’s always the bells and whistles – new features that come with new paint. It could be said that auto steer allows the operator to work longer days; new technology allows for better data management, that should lead to better decision-making.
“Just look at planters – they cost much more today than 20 years ago, and why? We now have trash whippers to manage residue; we have downforce with hydraulics; and maybe we have the ability to plant multiple hybrids from planter boxes with sensors,” notes Leibold.
“Is there value to those? Yes,” he responds. “It’s up for debate just how much value, or whether these add-ons justify the extra cost of new equipment.”
Even with all this advice it’s still a tough decision for most farmers, including Hettinger.
“It’s probably some of the harder decisions we have to make, other than marketing grain of course,” he concludes.
For more help
Custom rates and other equipment-related data including some spreadsheets:
Data and walk-through on how to estimate machine costs: