How fast should your farm grow in today’s environment? This question is difficult to answer. There are two main factors to consider: First, what is your farm’s sustainable growth rate without increasing leverage or looking for outside financing? Second, if your farm uses leverage to grow, what impact does borrowing money have on rate of return and financial risk?
Sustainable growth rate is the maximum rate of growth that a farm can sustain without having to increase financial leverage or look for outside financing. A farm’s sustainable growth rate can be computed using information on net farm income, owner withdrawals and net worth. Specifically, subtract owner withdrawals from net farm income, and divide the result by net worth. Owner withdrawals primarily consist of family living expenses, but also include money transferred out of the farm to invest in another business.
Net farm income minus owner withdrawals is often referred to as retained earnings. Increases in retained earnings increase a farm’s sustainable growth rate. Conversely, decreases in retained earnings decrease a farm’s sustainable growth rate.
Before discussing leverage, it’s important to discuss the importance of financial performance and owner withdrawals to a farm’s sustainable growth rate. First, even if the owner withdrawal rate is relatively low, a farm with low financial performance will have a relatively low sustainable growth rate. Second, a farm with a high financial performance and a relatively high owner withdrawal rate will also have a relatively low sustainable growth rate. Thus, the key is to focus on the magnitude of retained earnings, particularly in relationship to farm size as measured by farm net worth.
Leverage and debt
Financial leverage, or debt, influences a farm’s growth rate through its effect on expected returns and risk. The impact of financial leverage on a farm’s growth rate depends on the relationship between return on assets and the interest rate on borrowed funds.
As long as a farm’s return on assets is larger than the interest rate on borrowed funds, financial leverage will increase financial performance and the sustainable growth rate. However, higher financial leverage leads to an increase in financial risk. Specifically, as financial leverage increases, the potential loss of equity increases, the variation in expected return to equity increases, and the liquidity provided by credit reserves lessens. This is the difference between a farm’s operating line limit and operating funds borrowed.
The owner withdrawal rate has an impact on both expected returns and risk. As the owner withdrawal rate increases, expected returns decrease and financial risk increases.
In summary, a farm’s growth rate depends on financial performance, owner withdrawals and leverage. Leverage is often used to expand. When using leverage, it’s important to understand that leverage has the potential to increase financial performance, but also increases financial risk. It’s often a good idea to mitigate this increase in financial risk by reducing the farm’s exposure to marketing or production risks.
Langemeier is a Purdue University Extension agricultural economist and involved with the Purdue Center for Commercial Agriculture. He writes from West Lafayette, Ind.