The Rearview Mirror – Why bank ratios fail the modern-day family farm
“I think that every time you see the word EBITDA, you should substitute the words bullshit earnings” – Charlie Munger
The bank metrics are broken. There is no easier way of identifying this than through the words of the late Charlie Munger. Both he and Warren Buffett were highly aware that metrics used by financial institutions to evaluate businesses were often outdated and irrelevant when it came to the long-term profitability and viability of an operation. They would often exclaim about those companies that ignored depreciation, “Does management think the tooth fairy pays for capital expenditures?”
In agriculture today, we are falling into a similar existence. The majority of financial institution ratios are focused on past occurrences, not future outcomes.
So, how does a producer know what scoreboards to watch, or which indicators to track?
Working Capital
The first ratio to fall into irrelevance is working capital, or the current ratio. If I have $2 and I owe you $1, then I have a working capital ratio of 2:1. If you have $20M and owe the bank $10M, then you have a working capital ratio of 2:1. However, in realistic terms, you have $9,999,999 more available future cash than I do. The ratio is flawed.
The indicator that most farms need to identify is the comparison of working capital value to the total cost of production for next year’s operations. Now we take a comparison of the future liquidity from your current inventory and cash reserves and compare it against all of the cash outflows from the farm for the next year.
This will highlight the requirements around third-party financing, the timing of sales and purchases, as well as your ability to cover your obligations as they come due. The working capital ratio is a point in time: working capital in comparison to total costs provides future relevance around the liquidity and sustainability of the farm.
Many farms believe that debt around land, quota, or breeding herds is where farms get into trouble. The reality is that most farms create issues because of the increased annual operational costs that come with expansion.
Most operating lines grow on a per-unit measure, meaning that the farm needs to make up the remaining dollar requirements. For example, if you have $300 per acre of working capital and you double in size, you now only have $150 per acre of working capital to use for the next year.
Most farm failures begin with liquidity problems, not debt problems.
Debt Service
Primary producer profitability is not a constant. While in other industries a significant decrease in revenue is often linked to business failure, in agriculture it could be as simple as a hailstorm in July or a war in another part of the globe. Volatility is why outside capital does not invest in a grain or livestock operation.
Even though this is an annual ratio for most lending institutions, they do look at longer trends (three to five years) when evaluating sustainability around debt service. But read the fine print; for most lenders, this annual review does provide them with the ability to make adjustments to your lending around risk and rate restrictions.
The other flaw is that by relying on EBITDA, as Munger and Buffett put it, the tooth fairy is paying for capital. I have spent years arguing with farms over the validity of the claim that depreciation is a true cost. Most operations don’t include it in their budgets, cost of production, marketing returns, or any analysis outside of new equipment discussions. The determination is that currently many farms only treat this as a real cost when they trade the machine, and it gets dissolved into the new loan. The difference of cash versus accrual is very apparent when it comes to depreciation of capital. Debt service does not take into account the loss of value in the machine until you dissolve it into a new loan on a new piece of equipment.
Debt to Equity
The modern-day balance sheet of a farm is as accurate as the yield monitor in most combines. Any metric around equity or asset value done on a compiled balance sheet is irrelevant when it comes to farm net worth, debt-to-equity comparisons, and debt leverage analysis.
The accounting regulators allow farms to value short-term assets like inventory at net realizable value. However, the machinery, land, quota, infrastructure, and investments on a balance sheet are evaluated at cost. Most farms today bought their very first quarter of land for what a side-by-side costs. This is what value is recorded on the balance sheet for this asset. The average farm we work with is undervalued on the balance sheet by tens of millions of dollars. Appraisals and farmer Excel sheets are what drive the banking around equity and asset value.
This is why most farms need to keep an analysis of net worth annually. A fair market value balance sheet so that the true equity position of the shareholders and owners is evaluated each year and the true return (income) from these assets is calculated. If you analyse your income from what you paid for a quarter of land, you may see returns that compare with the stock market. If you do it based on the true net worth of that land, you will be in for a shock at how little you make for how much risk most farms have in operations.
Some will say these restrictions are in place to reduce the risk of failure or growth beyond a farm’s means. Others will say they exist because banks don’t truly understand how to work with industries like primary production agriculture.
Either way, the modern-day farm is going to change the way banking is done. Consolidation will continue, access to capital will be required, private equity and new forms of capital will force the banks to adjust. There will be farms that fail, and there will be farms that prosper beyond what we determine possible today. And you can bet your bullshit earnings on that.
