Month: April 2018

Is Net Farm Income Affected by Debt Levels?

# Introduction
Net Farm Income (NFI) is probably the ultimate measure of farm success. Farms that generate an adequate income can cover family living expenses and will remain viable operations. Farming requires a substantial amount of capital though for the business to function. Debt capital is used by nearly every farmer but farms vary in their use of debt. Debt capital is not free and any interest expense will lower NFI. However, debt capital can help a farm become larger which could improve net farm income. In the paper AgManager GI-2018.8, I examined farms by quintiles based on the D/A ratio to determine the level of risk for farmers in the Kansas Farm Management Association (KFMA) program. While there is a wide range of debt levels among farms, there is a question about how this debt affects farm profitability. This paper examines the net farm income by quintiles of the D/A ratio.

# Procedure
To generate the quintiles, the D/A ratio for all the farms each year are ranked in order from highest to lowest. The 20 percent of farms with the highest D/A ratios are put into group one, the next highest set of D/A ratios are in group two, etc. The bottom 20 percent of farms with the lowest D/A ratios would be in group five. Once the grouping of farms is established, the average net farm income for each group is calculated.

# Results
Figures 1 and 2 show the average net farm income for the different quintiles. The results are broken into two parts to make the trends easier to read. Prior to 2006, most farms had NFI below $100,000. After 2006, the increase in grain prices greatly increased the NFI of all quintiles. Thus, 2006 made for a good point to divide the results. Notice that the two figures have different Y-axis scales. Figure 1 also has removed quintile groups 2 and 4 to make it easier to read. Groups 2 and 4 have results that fit into the range of the other three groups.

Average NFI by D A Ratio Quintiles

Copy of Average NFI by D A Ratio Quintiles

As the figures show, group one, the group with the highest debt-to-asset ratios tended to have the lowest net farm income. The other four groups tended to have NFI that was closer together which made it difficult to say that one group had higher net income than another. One reason why the highest leveraged farms had the lowest NFI may have been because these farms were also the smallest.

Figure 2 indicates that the highest leveraged farms did not see the big increase in NFI from 2007 until 2014 that the less leveraged farms did. However, the farms with very little debt didn’t see as much of an increase in NFI over this time period as did groups two, three, and four. Thus, it appears that farms with moderate debt were the ones to benefit the most from the higher grain prices of 2007 through 2014.

An important observation from Figure 2 is that the farms with very little debt had the least variability in net farm income. While these group five farms had the second lowest NFI from 2007 until 2014, these farms had the highest NFI in 2015 and 2016. Farms with the highest leverage, group 1, have been hit the hardest by the current downturn in the farm economy. However, during the peak of the 1980’s farm crisis, these group 1 farms were even in worse financial shape as there were 6 years in a row where their average NFI was below zero. The higher interest rates of the 1980’s were likely a factor contributing to these lower NFI for highly leveraged farms.

Comparing Interest Rates Paid by Farmers

Introduction

Debt capital is important for farmers to build an asset base that is sufficient for their farming operation. The average Kansas Farm Management Association (KFMA) farm has $2.7 million in assets with $600,000 of these assets in borrowed funds (i.e., debt capital). The median debt to asset ratio is 20%. Even with the current historically low interest rates, interest expense is a significant item for most farmers. The average KFMA farm paid $26,000 in interest expense in 2016 which is the highest amount ever.

Because interest on borrowed capital can be a major expense on a farm, anything a farmer can do to lower their interest rate can improve overall profitability. With $600,000 in debt on the average KFMA farm, a 1% change in the interest rate will result in a $6,000 change in the interest expense. The purpose of this article is to examine the rate of interest that farmers are paying to see if it is comparable to other interest rate benchmarks that banks charge to other non-farm customers.

Procedure

The KFMA effective interest rate is compared to the Bank Prime Loan Rate (PRIME or MPRIME for monthly data). Prime is a Rate posted by a majority of top 25 (by assets in domestic offices) insured U.S.-chartered commercial banks. Prime is one of several base rates used by banks to price short-term business loans. (Board of Governors of the Federal Reserve System (US), Bank Prime Loan Rate [MPRIME], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MPRIME, April 5, 2018.)

The Prime rate is posted daily and the monthly reported figures, Mprime are an average of daily figures. In this paper, the KFMA effective interest rate can only be computed once a year so the monthly Mprime rate is averaged across months to get a yearly value.

The KFMA effective interest rate is computed on a farm by farm level by taking the total intest expense (both cash and accrued interest) and dividing by the total amount of debt on the farm. The total debt is an average of the beginning and ending balance sheet numbers. The yearly numbers are aggregated by using the median effective interest rate.

MPRIME 2018 7

Results

The comparison of the bank Mprime rate and the KFMA effective interest rate is shown in Figure 1. As can be seen, the rate paid by Kansas farmers matches very closely to the Mprime rate. Since 1983, the correlation between the two rates is 0.91. The KFMA rate appears to have less volitality which is probably due to the combination of long-term and short-term borrowing combined together while the Mprime rate is a short-term rate. Thus it appears Kansas farmers have been doing a good job of controlling their borrowing rates. With the federal funds rate on the rise, farmers who haven’t done so may want to look at rolling shorter term loans into longer term loans.

Debt Levels of KFMA Farms

Introduction

The current median debt-to-asset (D/A) ratio for all farms in the Kansas Farm Management Association (KFMA) is 20%. While this number is usually considered very good, half the farms have ratios higher than this. The median value has no way to show the variability of financial risk that some farmers have so other ways of examining the D/A ratio are needed. This article examines the quintiles of the D/A ratio to see how much variation there is in the risk level of Kansas farms.

Procedure

To generate the quintiles, the D/A ratio for all the farms each year are ranked in order from highest to lowest. The 20 percent of farms with the highest D/A ratios are put into group one, the next highest set of D/A ratios are in group two, etc. The bottom 20 percent of farms with the lowest D/A ratio would be in group five. Once the grouping of farms is established, the median D/A ratio is calculated for each group. The median works better than the average for these type of calculations as some financial ratios can distort averages. This would occur for farms in group one particularly.

Results

Figure 1 shows the median D/A ratios of each of the five quintiles when farms are ranked by their D/A ratio. Group one, with the highest D/A ratios, has a median ratio of almost 70 percent. While this number is high, it is actually below what it has historically been. Back during the 1980’s farm crisis, this highest risk group had a median value above 100 percent. The other four groups have median D/A ratios that are more in line with standard norms for acceptability. The group five set of farms carry very little debt. In fact, the median D/A ratio for these farm is zero.

Quintiles of D_A Ratio.pdf

While Figure 1 shows that all groups have reduced their median D/A ratios since the farm crisis of the 1980’s it has not been the case that farmers have reduced their debt. As shown in Figure 2, the three groups with the highest level of financial risk have increased their debt levels substantially while the two groups with the lowest level of financial risk have not increased their debt levels very much.

Median Debt by D_A Ratio Quintiles.pdf

The major reason that D/A ratios increased during the farm crisis was that asset values (i.e., land values) declined. When comparing Figures 1 and 2, notice that farmers stopped adding debt from 1980 through through the mid 1990’s. Meanwhile the D/A ratios continued to climb until about 1986 because of declining land values. Thus, the numerator in the ratio stayed the same while the denominator in the ratio decreased resulting in a higher D/A ratio. The reverse situation happened from about 2002 until 2015. In this timeframe, farmers added debt but their D/A ratio stilled declined. This occurred because land values rose faster than the debt added. One interesting point from Figure 2 is that group one (with the highest D/A ratios) has nearly the same amount of debt as group two. This would indicate that group two farms are bigger in size. Farmers with the highest D/A ratios are mostly likely younger, beginning farmers (note: a future paper will investigate the age aspect of farm debt).

Conclusion

Debt to assets ratios appear to be at acceptable levels now. However, as the farm crisis of the 1980’s showed, D/A ratios are really a trailing indicator of problems. Farms have added a lot of debt during the past 15 years. So far this has not been a problem thanks to rising land values. However, a repeat of the 1980’s where land values declined significantly could change the D/A picture considerably.