If the farm adjacent to yours came up for sale would you be able to take opportunity and buy the land? Or, would your lender say “no” because you’re too highly leveraged and aren’t liquid enough?

If you don’t know the answer, you need to keep a closer eye on your liquidity status. As you track liquidity and stay in contact with your lender you will be well positioned to take advantage of opportunities that come your way. 

How do lenders measure liquidity? They look at your balance sheet, farm business analysis and cash flow.

Liquidity is your business’ ability to meet financial obligations as they come due. In other words, you have enough cash to pay your family living and operational expenses, taxes and make all debt payments on time.

Being liquid lets you take advantage of buying extra land or build facilities to expand your operation. In all cases, liquidity provides flexibility in your business plan.

Lenders look at the current ratio. This measures the extent to which current assets, if sold, would pay off current liabilities.

To calculate the current ratio, take:

Total current farm assets ÷ total current farm liabilities = current ratio.

For example, $322,014 ÷ $246,712 = 1.30522.

“Lenders are comfortable with $2 of assets per $1 of debt—that is a 2:1 ratio of assets to liabilities,” says Gary Thome, farm-business-management instructor, swine specialist, RiverlandCommunity College, Austin, Minn. “Pork operations run in the 1.3:1 to 1.6:1 range, which is pretty typical across the board, depending on market conditions.”

Keep in mind that all market animals are considered current assets, and the ratios are affected by the day-to-day market. So if market prices change by $10 per head, the ratios can change. For efficiency and productivity, you can look at those numbers annually or semi-annually.

“Pork production can be a risky business,” explains Rich Pottorff, agricultural economist, Doane Advisory Services. Cash hog prices often vary over a $30 range and there is a lot of variability in production costs. Some of these price swings can be predicted, but often times an unexpected event has a big impact on production profits.”

Who doesn’t remember the 1998/1999 disaster when cash-hog prices dropped to single digits, wiping out profits and eating into net worth.

“In the future, the threat may come from the cost side,” says Pottorff. “With ethanol’s corn demand soaring and corn export demand showing signs of strength, hog prices that produce a profit today may be inadequate in the years ahead.”

Sudden and often unexpected changes in profit make it extremely important for producers to manage liquidity, says Pottorff. Failure to accomplish this can put the entire operation at risk because it can wipe out your working capital, and it robs your business’ ability to adjust.

The number of pork operations dropped by about 12 percent from 1998 to 1999 as the dismal prices drove producers out of business.

Along with the current ratio, lenders look at your working capital. It illustrates the short-term working capital available within the business.

To calculate current working capital, take: current farm assets – total current farm liabilities = working capital. 

For example, $322,014 - $246,712 = $75,302.

Current ratio and working capital change the fastest. Current assets are those items that can be turned into cash easily. Conversely, current liabilities are due within the next year.

For instance, look at a producer with a 1,000-head finishing barn. His ratio may look positive when the pigs are ready for market. He can sell the hogs, not use the money to pay off debt and the ratio will change negatively because he no longer own the hogs, which were considered assets.

“I like to see a producer have four to six months of monthly operating expenses available as working capital,” says Thome. “That’s not always easy to do, especially for producers with crops — they spend more money in the spring for inputs and don’t get crop money until fall.

Another consideration is the operating line of credit the producer has established.” A lender will look at the credit amount and determine if a producer makes regular payments or continues to run up the amount.

Now that you’re tuned into business liquidity, it’s time for your lender to do the same.

How does a lender evaluate if a producer is a sound borrower or is a troubled loan in the making? One warning sign is that a single pork operation supports too many families. Another is that excessive school and college expenses swell family living expenses beyond what’s reasonable to expect the farm to generate. Perhaps a producer is working too many hours off the farm, which causes critical farming tasks to be neglected and damages farm profit.

To avoid some of these problems, Thome suggests it’s a combination of looking at your working capital and current ratio, but most importantly, cash flow.

For example, if the pork market drops, your hog inventories are worth less and the dollars coming in to pay debts are less. If you have crops, your cash flow may be based on income from 180 bushels an acre, but if there’s a drought, you may get only 140 bushels an acre. Such scenarios can affect your current and future cash flow.

Thome says you can adjust for these situations if you:

  • Delay capital purchases. For example, repair the feed bins instead of installing new ones this year.
  • Reduce family living expenses. Don’t eat out as often and consolidate your trips to town to save gas.
  • Minimize per-unit production costs-- think about every dollar you spend. Do you regularly adjust hog feeders and waterers to minimize waste? Are there ways to cut back on fertilizer for cropland?

There also are general warning signs that an individual borrower can’t control, but that can mean trouble. Thome cites some of those:

Low commodity prices.

  • Drought or excessive rain. Thome suggests that you have crop insurance in the case of either event. Back off on forward contracting, and purchase options if prices are favorable and crop yields are questionable.
  • Changes in government-support policies. Lenders are highly aware of how much net farm income comes from government-support programs.

Thome points out that there are steps that a producer may take over a period of time that illustrates a financial problem to a lender. Determine if you fit into the following scenario.

“Over a period of years, if a producer tends to have a general cash-flow shortage. Perhaps buildings aren’t repaired or repainted; and machinery isn’t upgraded or fixed like it should be,” notes Thome.

Next, the producer puts off all possible purchases. Eventually he ends up having open accounts with several vendors -- veterinarians, feed dealers and local equipment dealers. As the accounts grow, the producer turns to credit cards.

Once an individual gets to this point, he’s in a bind when it’s time to upgrade a building or buy a new piece of machinery. The regular lender won’t loan the money, so he goes to another lender or applies for a company credit card from a large equipment dealer.

This is just one example of financial warning signs that a lender will review the next time you need a loan. (See sidebar for a list of more warning signals.)

“In the last 18 to 24 months with the input prices—corn and soybean meal-- we’ve seen, and hog prices for producers, there’s been a tremendous healing of working capitol and ratios,” says Thome. Producers are upgrading equipment and facilities because the funds are there. More are staying in business by increasing productivity.

“We’ve moved away from the day where a person can get a half-way-decent return on assets and still make a living,” says Thome. “Now, producers have to be very financially sharp to stay in business.”

Those producers work with their lenders to make sure they have enough liquidity to survive the market’s ups and downs.

The question is; do you fit into that category?

Reading Financial Warning Signs

Reading Financial Warning SignsThere are many warning signs that your lender will use to determine if you are a good loan risk. Here’s a list that Gary Thome, farm-business-management instructor, swine specialist at RiverlandCommunity College in Austin, Minn., cites as a starting point. The lender will ask, is there:

  • A major change in crops grown or livestock produced.
  • Split lines of credit with two or more lenders.
  • Too many credit cards and too much vendor credit.
  • Failure to provide timely financial information.
  • Incomplete or inaccurate financial information.
  • Failure to comply with loan agreement covenants.
  • Failure to keep appointments with creditor.
  • Cutting corners on vital inputs.
  • Deterioration in the appearance of the property or facilties.
  • Deferred maintenance on machinery and equipment.
  • Speculation activity in the futures’ market beyond the farm’s production.
  • Action to adopt new, expensive technology too quickly.
  • Action to adopt proven, profitable technology to slowly.
  • A deterioration in the business’ financial ratios.
  • A deterioration in consumer-credit rating.

Thome says that credit scores run from 300 to 900, with 60 percent of people falling around 650 and higher.

With a score of 800 or above, less than 1 percent of consumers fail to pay their bills on time. For people with a score of 700 or higher, only 5 percent or less are ever delinquent with payments.

When someone drops below 650, lenders become concerned. With scores between 600 to 650, 31 percent of consumers have delinquent payments. For those who fall below 500, records show that 87 percent have delinquent payments.

The 7 Habits of Effective Producers

Are you an efficient and well-rounded producer? According to David Kohl, professor emeritus, Agricultural and Applied Economics at Virginia Polytechnic Institute and State University, these seven traits constitute an effective producer:

  • Be objective
  • Manage risk
  • Think in terms of systems rather than components
  • Make prudent, informed decisions
  • Manage human relationships
  • Communicate thoroughly (that means listening too)
  • Exercise your mind, body and spirit

How’s Your Financial Management Potential?

David Kohl, professor emeritus, agricultural and applied economics at Virginia Polytechnic Institute and State University, sees only one in five individuals he would consider true agribusiness managers. He outlines a few traits of those with the most management potential.

Those who look to generate profit through:

  • Lower overhead
  • Cost control
  • Cash-flow management
  • Liquidity
  • Astute marketing