Farmers’ credit world


According to USDA about 97% of the United States’ 2.1 million farms are considered family farms and 88% of all U.S. farms have a gross cash farm income of less than $350,000 annually, putting them in the small family farm category. This means that most farms in the U.S. are small, family-owned businesses that rely on the availability of finance options to fund the high cost of producing the food, fiber and renewable energy our country and the world rely on every day.

According to USDA’s most recent Farm Sector Income Forecast, interest as an expense increased by about 43%, or $10.3 billion, to $34.42 billion in 2023. Interest rate hikes have not only increased the cost of credit as an input but have also limited farmers’ ability to use it. This Market Intel will give you a glimpse of farmers’ credit world and explain how changes in that environment could lead to challenges with liquidity, a problem that is hard to fix.

An extremely important part of farm finances, farm liquidity is “the ability of a farmer to generate cash quickly and efficiently in order to meet his or her financial obligations.” Some assets, such as corn in storage, can be sold and turned into cash quickly and are considered assets with high liquidity. Others, such as a crop that was recently planted or livestock that have not yet been born, take more time to turn into cash and can require additional input expenses to become the final product for sale, such as grain or marketable livestock. When farms get tight on cash due to the high cost of operating or from overspending, lack of liquidity can become a real problem.

Liquidity is measured using several different accounting ratios. Working capital is not a ratio, it is a measure in dollars of total assets minus total liabilities. This is a measure of available cash.  Working capital needs are highly variable by farm size, exposure to risk and volatility of the overall business environment. When net returns are more variable, more working capital is needed. Due to these differences, it is helpful to measure working capital by either gross revenue or value of farm production.

One of the most used liquidity ratios is the current ratio. The current ratio (sometimes called the “working capital” ratio) measures a farm’s ability to pay off debt due within one year. It is the ratio of current assets divided by current liabilities. A current ratio of 2 or higher is considered good. Anything below 2 is cause for concern.

The debt service ratio, sometimes called the term debt coverage ratio, measures a farm’s ability to use operating cash flow to pay debt obligations. Lenders typically like this ratio to be 1.5 or greater. A ratio of 1 would mean that the farm has adequate cash flow to meet payment obligations. A ratio less than 1 would mean the farm falls short and will have to rely on other resources to service debt.

It is helpful to evaluate working capital needs in comparison to gross revenue or value of farm production. The working capital-gross revenue ratio is a measure of whether or not a farm has adequate working capital for its level of gross revenue. A farm with a ratio of 30% or greater is considered strong, 10-30% is cause for concern, and a ratio less than 10% is considered vulnerable.

The interest expense ratio shows how much gross income is being used to pay interest on debt. In years when interest rates are low, this ratio may be overlooked as it remains well within healthy parameters. However, when interest rates go up, the interest expense ratio can be a stark reminder that taking on unnecessary debt or too much debt can be costly. When more capital is being used to pay for interest, it means less capital is being paid toward equity-building principal.

Farmers have many recurring annual costs such as land rent, input expenses and debt payments. A farm with strong liquidity has cash available to pay these recurring costs and potentially pay for growth such as new land or equipment purchases.

Problems with liquidity can arise from changes in the financial environment. For example, when costs of inputs such as fertilizer, seed and fuel go up, it takes a greater amount of working capital to pay for them. When working capital is depleted, farmers have a variety of options to help liquidity. Selling cash assets such as crops in storage may be an option but may be costly if market conditions are not favorable. One of the most common solutions to liquidity is through a variety of credit-based solutions such as operating loans. While credit-type solutions can be a great option, they can be expensive and endanger the long-term sustainability of a farm.

U.S. farm sector liquidity has been good and strengthening since 2020. However, the recent drop in ad hoc government assistance combined with Federal Reserve-driven interest rate hikes and increasing operating costs have changed the financial environment.

The debt servicing ratio used by ERS is a modified version of the term debt coverage ratio. USDA uses this ratio to measure the share of production plus direct government payments that are used to pay off farm sector debt. A higher debt servicing ratio implies that a greater share of production is needed to pay off debts. ERS forecasts the ratio to rise from .21 in 2022 to .24 in 2023. Higher cost of debt from sustained elevated interest rates could lead to continued debt servicing ratio growth in 2024.

While ag sector liquidity has been strong in recent years, the financial environment has changed and high interest rates are adding another expense to farmers’ lists of rising input costs. Operating loans and other forms of financing cost farmers a whopping 43% more in 2023 than in 2022 and are forecast to remain elevated for much of 2024, causing working capital stocks to decline faster and forcing farmers to lean on expensive credit to provide liquidity. When farmers pay more for interest on that credit, less money gets paid toward principal. The amount of income being used to pay interest on farm debt in the U.S. has increased at a rate not seen since the 1980s. There are many tools available to help farmers persevere when liquidity makes their business vulnerable, but it’s important for decision makers to remember a lesson from the 80’s. Short-term borrowing during times of vulnerability can turn into costly long-term debt. Excellent management and decision making are a must to remain resilient during times of vulnerability.

“Money isn’t the most thing in life, but it’s right up there with oxygen on the ‘gotta have it’ scale.” -Zig Ziglar

Ron Kern is the manager of the Ogle County Farm Bureau.