Category: KFMA analysis

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.

Family Living for Kansas KFMA Farms

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Most farm families depend on income from their farm business to cover their family living expenses. Thus, one would expect there to be a strong correlation between net farm income and family living. It turns out there is a fairly strong correlation of 0.62. However, as the figure above indicates, there is a lag before family living adjusts.

Net farm income increased substantially in 2007 for grain farms in Kansas and other states thanks to much higher grain prices. Net farm income remained higher than average through 2013 before starting to decline in 2014. As can be seen in the figure, farm families did not start to adjust their family living until later. The figure above is based on real dollar amounts so that historical numbers are comparable to current dollars. Family living went from around $50,000 before the increase in net farm income in 2007 to around $70,000 now.

Now that net farm income has declined for two years, family living expenses are only now starting to decline. 2015 saw net farm income fall to a near record low for Kansas KFMA farms. However, the drop in family living was not nearly as great. The question going forward is what happens if net farm income is again at very low levels in 2016. Will farm families be able to adjust their family living downward at a rapid rate. As nearly any family can confirm, adjusting spending upward when there is additional income is an easy thing to do. Adjusting spending downward is not nearly as easy

Update to Kansas Net Farm Income

Net farm income (NFI) for the Kansas Farm Management Association (KFMA) was near a record low for 2015, even when adjusting for inflation. The average net farm income for the entire state and for all farm types was less than $5,000. The median NFI for 2015 was only slightly better at just over $9,000. You have to go all the way back to 1981 to find a lower average NFI. The figure below shows the inflation adjusted average and median NFI for the entire state and for all farm types. Older values were adjusted by the CPI index so that comparisons across time could be more accurately made. This adjustment makes a dollar in the past comparable to a dollar today.

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While the average and median values show a lot about what happened to farm income in Kansas across time, the use of these measures tends to obscure much of the details of how different farm segments are faring. To show how a broader cross section of farms is doing, NFI for all the farms in a given year are ranked in order and the NFIs are divided into deciles. Thus, the top 10 percent of net farm incomes would be in decile number 1, the second 10 percent of net farm incomes would be in decile number 2, etc. The lowest 10 percent of net farm income farms would be in the lowest decile (#10). Every year, the net farm incomes are re-ranked so a farm may move among decile groups across time depending upon the level of net farm income compared to the other farms. 

By using decile groups we can see how the entire cross section of farms is doing in any one year. In particular, the farms in the bottom two or three decile groups are of interest as these are the farms most at risk when the state average NFI is low. 

The next figure shows the net farm income by decile group for the entire state from 1975 through 2015. As can be seen from this figure, decile groups 3 through 8 are usually fairly consistent across time. These groups usually earn between $0 and $100,000 when adjusted for inflation. Even during the period from 2007 through 2013, when average net farm income increased greatly, these middle deciles groups showed more consistent net farm income. 

 

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The large increases in average net farm income from 2007 through 2013 can mainly be attributed to the top two decile groups. These top earning farms helped to bring up the overall state average from $55,000 in 2006 to $132,000 in 2007 (adjusted for inflation). 

By contrast, the bottom decile group tends to lose money in a given year while the ninth decile group tends to break even. Even during the very profitable years from 2007 through 2013, the bottom decile group lost money. Keep in mind though, the bottom 10 percent of farms is not the same each year.

This past year in 2015, net farm income resembles what happened in 1981. In 1981, the bottom decile group lost $245,000. In 2015, the bottom decile group lost $306,000. Also, in 1981, decile groups 6 through 10 lost money. In 2015, groups 7 through 10 lost money and the 6th decile group averaged less than $1,000 of NFI.

2015 was a very difficult year for many farms across the state. Although the average NFI was positive, four of the decile groups averaged negative NFI while the next group had an average NFI close to zero. Thus, nearly 45 percent of the KFMA farms lost money in 2015.

Full details on this article can be found at Net Farm Income by Decile Group – A Historical Comparison

Net Farm Income for Kansas by Decile

 

 NFI by profitability decile

Figure 1. Net Farm Income by Decile for KFMA Grain Farms

 

 

Lower grain prices the last several years have helped to decrease net farm income for grain farms in the Kansas Farm Management Association. Net farm income for these farms is shown in the figure by deciles from 2002 through 2014. The deciles are calculated by ranking the farms in order by net farm income each year and then putting the top 10% of farms in the 1st decile, the second 10% of farms in the 2nd decile, etc. During the years from 2007 through 2012 when average net farm income was very strong, it was the upper 10% of farms that was really raising the average. For the most part, the largest percentage of farms in any given year earn from $0 to $100,000. 

As the figure indicates, the 9th decile usually breaks even while the bottom decile normally loses some money each year. Fortunately, the farm makeup of this bottom decile changes so that farms are not consistently in the bottom decile. The last two years have seen a dropoff in net farm income as grain prices have declined. The affect of these lower grain prices has probably had a more profound affect on the bottom 2 deciles. 

 

 

Bottom 2 deciles NFI

Figure 2. Net Farm Income for the Bottom 2 Deciles of KFMA Grain Farms

 

Figure 2 isolates how the bottom 2 deciles have been affected by lower grain prices. These two groups lost a considerable amount of money in 2014. The 9th decile, which normally earns very little net farm income but also normally loses very little net farm income, lost nearly $30,000. The bottom decile lost well over $150,000. Loses of these amounts will quickly put farms in a precarious financial position.  If these farms want to maintain their level of family living, the cash will need to come from a reduction in their equity, an increase in debt, or from some outside revenue. Obviously farms cannot lose this amount of income and hope to be viable operations very long.