Last time, we talked about the working capital burn rate (WCBR)–a measure of how many years of losses a producer can sustain before they exhaust their working capital and have to either refinance their land to withdraw equity, or take some other drastic action. This time, I want to discuss the land equity burn rate (LEBR). The LEBR measures how long a producer can continue to take those drastic actions before all of the value of the farm is gone.

The LEBR is calculated by dividing the amount of equity the farm has in its land and buildings, i.e. their market value minus debt owed on them, by the annual loss. There are a couple of points to understand about the values used for this calculation. First, use only the equity in land and buildings–these are assets that have clear collateral value and lenders will readily lend against. Second, use the current market value of these assets–not what they were worth in 2013. Third, instead of using taxable profit use cash flow–ignore depreciation and amortization, but add in both family living expenses and debt payments, this is a better approximation of the health of the operation.

Going back to the same groups that we used last time from FINBIN, we calculated the LEBR for the three least profitable quintiles.

The least profitable quintile has an LEBR of 7.5, meaning that at the current rate of losses, there are only 5.1 years of equity left in the operation. The second quintile is in a much better situation at 11.4 years, while if the 76 years in the third quintile ever becomes relevant, there are bigger issues in the economy to worry about. Turning our attention, though, to the first quintile, these are operations with an average of 1/2 of a year of working capital, i.e. they’ve already run out of cash, and they only have 5 years left of these conditions before the farm must not only be sold, but there will be almost nothing left over after the sale. These numbers also assume that these asset values are still current. If we reduce these asset values by 10%, as might be reasonable based on changes in the past year, then the LEBR for the lowest quintile drops to only 4.4 years. On the other hand, Dave Kohl suggests ‘stress tests’ based on 25% declines in land values(!), which would drop that lowest quintile LEBR to only 3.25 years.

That is why these ratios are potentially so powerful–they put a farm’s situation in a very easy to understand single number. In an industry in which one of the primary goals is pass this operation on to the next generation, knowing how many years they can keep going ‘business as usual’ can be powerful, and powerfully upsetting.

Since 2009, just after the first time corn prices ran to $8, I’ve been emphasizing to growers than they need to build working capital. Early on, I used a pretty simple rule of thumb: growers need at least one full year of land charges in extra working capital. This extra working capital was cash that could be lost when prices inevitably turned lower. But that was a time of high prices and profitability, when it was easy for growers to build stronger balance sheets. In 2016, easy profitability is a thing of the past. Many growers will be lucky to have breakeven cash flow, so telling them to build cash reserves is not helpful. Instead, I’m now emphasizing that growers who are expected to lose money in 2016 calculate (and watch) their working capital and land equity burn rates. These are two quick measures of the precariousness of growers’ current financial condition, and indicate the urgency that farmers should use in undertaking managerial changes. In this post, we’ll focus on the working capital burn rate and why it matters. Next time, we’ll discuss the land equity burn rate.

Before going any further, let’s review a little bit of accounting. According to the New York State Society of CPAs, working capital is equal to current assets minus current liabilities. Current assets are assets that one can reasonably expect to convert into cash, sell, or consume in operations within a single marketing year, or within a year if more than one cycle is completed each year. For a crop farm, this is cash, securities, pre-paid inputs, grain inventories, deferred payments, and any other accounts receivables. Current liabilities are obligations that must be met within the marketing year. For a crop farm, these are primarily this year’s payments for long term debt, operating loans, and any other obligations that are due in the current marketing year. The WCBR is simply working capital divided by 2016’s losses. It is a measure of the number of years that the operation can sustain 2016 market conditions before working capital is exhausted. This is important as its a measure of how long the farm can continue to operate before being forced to change its capital structure, either by selling, shrinking, or refinancing; in other words, it’s the number of years that a grower can continue to operate before being forced to make major changes.

Using 2015 FINBIN data, we can construct some examples for 2016. Using data on crop farms with 2000+ acres, separated into quintiles1 FINBIN reports 373795 and 373797 by profitability allows us to see the situations that some farmers will find themselves in this year, and potentially more farms will be in in 2017. To approximate 2016 crop income, I’ve reduced total crop sales, and therefore profits, by 10% in line with the 2016 market year average estimated prices for corn, soybeans, and wheat compared to 2015.

Column 1 is the 144 least profitable crop farms with 2000 or more acres in the FINBIN dataset. When their profits are further reduced by 10% of crop sales to represent hypothetical returns, their projected losses are over twice their current working capital, resulting in a WCBR of less than one year–these farms are already on life support, and need to take drastic actions now. These are the farms that likely couldn’t renew their lines in 2016, and even if they somehow did, will have to refinance during 2016 just to get the bills paid. In column 2 are the bottom 20%-40% of farms. These farms are in a less dire situation with a WCBR of 3  years–enough time to hopefully adjust land rents, and maybe for prices to improve somewhat. But without those changes, renewing the operating line in 2017 will be more difficult, and likely impossible in 2018. Finally, the middle 20%, those from 40%-60%, have a burn rate of 24 years–demonstrating more than adequate working capital reserves to weather these next few years.

In the next post, we’ll discuss the land equity burn rate, LEBR, which is the ultimate ‘last ditch’ measure of a farm’s ability to survive by measuring how long equity can be drawn down to finance further losses.

(Part 2: The Land Equity Burn Rate)