Business Management

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“Fact Sheet #540: Assessing and Improving Your Farm Solvency”

  Perhaps the farm has been in your family for generations, or maybe you purchased it just a few years ago. Regardless of how long the farm has existed, it is your responsibility as farm manager to maintain the farm's long-term financial stability. This fact sheet will help you with this task by discussing net worth, solvency and the use of a balance sheet.

What Is Net Worth and Solvency?

Net Worth

  Net worth, sometimes referred to as owner's equity, is the difference between the value of farm assets and the liabilities against those assets.

  Assets are items owned by the farm business, such as land, buildings, machinery, livestock, crops in storage, and supplies. Liabilities are the debts owed by the farm business. Net worth, therefore, represents your equity in assets or their remaining value if you were to sell the business and pay off the farm's debts. You may think of assets as your accumulated wealth.

Solvency

  Solvency is a long-run concept that addresses financial security. Net worth is the absolute measure of solvency. If the value of your assets exceed your liabilities-a positive net worth-your business is solvent. But net worth does not indicate how vulnerable the business is to changing financial conditions. A relative measure of solvency, the debt/asset ratio, indicates the future security of your farm's financial position. The debt/asset ratio is calculated as:

  A debt/asset ratio of 0.40 indicates that for every dollar of assets, forty cents is owed. How do you use the debt/asset ratio to measure financial risk? Suppose the Whitmer farm and the Harris farm¹ each have a net worth of $210,000. However, the Harris farm has twice the assets of the Whitmer farm and three-and-one-half times the liabilities, giving it a debt/asset ratio of 0.70 compared to 0.40 for the Whitmer farm (Table 1).

¹ The Whitmer and the Harris farms are fictitious farms used here as examples.

  A 20 percent decline in the value of the assets due to market conditions would result in a new value of farm assets of $280,000 for the Whitmer farm and $560,000 for the Harris farm. Since the value of liabilities would not change with the decline in asset value, the net worth on the Whitmer farm would decline$70,000 giving it a net worth of $140,000, while the net worth on the Harris farm would decline twice as much$140,000-giving it a net worth of only $70,000. The Harris farm is in a more vulnerable financial position and this is indicated by the higher debt/asset ratio.

  What criteria can you use to compare the net worth and debt/asset ratio for your farm? Evaluating net worth depends on the characteristics of the farm. A young farmer just starting in business would not have had the time to accumulate the net worth of someone who has been farming for several years. Likewise, a given level of net worth that must be divided between two or more owners of a farm would not be as favorable as a farm that only has one owner. Each person must make his or her own judgments about the level of net worth by keeping in mind that a higher net worth indicates more accumulated wealth.

  The safety level of the debt/asset ratio also depends on the characteristics of the farm. Generally, a debt/ asset ratio of less than 0.40 is considered safe, a debt/ asset ratio greater then 0.70 is considered risky, while a debt/asset ratio between 0.40 and 0.70 would call for some caution.

  While higher debt loads in a farm operation may be risky, debt, in itself, is not bad. The idea of leverage suggests that you can use borrowed money to earn greater returns for your farm operation. Farmers borrow money because the returns generated from investing in the business generally exceed the interest expense of that debt. However, it is important to balance the benefits of leverage against the risk involved. Many leveraged farmers who were well-off financially in the seventies faced financial stress when the economic climate turned against them in the early eighties.

  Analyze your farm's net worth and the debt/asset ratio over time to determine trends in the farm's solvency position. A farmer who has calculated these measurements for several years can spot positive or negative trends and make appropriate management decisions regarding the farm's future.

How Do You Improve Your Solvency Position?

  The best way to improve your solvency position is to improve profitability. Profitability drives solvency. If the farm is not making a profit, then family living expenses are probably eroding net worth. Fact Sheet 539, "Assessing and Improving Farm Profitability," provides a comprehensive review of "profit" and "profitability" and ways to improve your farm's profitability.

How Do You Use a Balance Sheet To Analyze Net Worth?

Balance Sheet or Net Worth Statement

  A balance sheet or a net worth statement, is a detailed listing of assets, liabilities and net worth at a given point in time. It balances assets against liabilities and net worth (Figure 1).

Figure 1. Diagram of a balance sheet

  The format of the balance sheet follows this pattern by listing assets on the left-hand side and liabilities and net worth on the right-hand side. Farm assets are divided into three categories according to their length of life, their cash liquidity, and their effect on production in the farm business. The categories are called current, intermediate- and long-term farm assets. A fourth category lists nonfarm assets.

  Liabilities are also grouped into three farm liability categories and a nonfarm liability category. Farm liabilities are classified according to due dates and correspond roughly to the assets against which they are claimed.

Market Value Versus Cost Approach

  Listing values for liabilities is straightforward since you can determine exactly how much you owe. However, estimating your assets is more difficult because their present value is probably different from their original cost. For this reason, there are two usual methods for valuing assets: the market value approach and the cost approach.

  The market value approach rates assets at their estimated current market value. The cost approach rates assets at their original cost plus cost of improvements minus the depreciation value. Each method provides useful information about your farm. The market value approach accurately estimates the present value of assets and net worth. The method is most useful for determining the absolute solvency position of your farm. However, the cost approach avoids "paper gains or losses" from fluctuations in market values of assets so that any change in net worth can be attributed to the actual performance of the business.

  Market value approach. The following guidelines are useful when valuing assets using the market value.

• Use well established markets when determining asset values.
• Be realistic with price expectations.
• Value current assets to be sold in the coming year, such as crops and market livestock, at current market prices minus any marketing costs.
• For machinery and equipment, review their book value on the farm records so as not to overvalue their market price.
• Consider the obsolescence factor when puffing a market value on machinery and buildings.
• When comparing the value of your farm with other nearby farms that have sold recently, consider the differences between the farms and also the income producing potential of your farm.
• When valuing intermediate- and long-term liabilities, subtract selling costs such as those associated with selling real estate.

  Cost approach. The following guidelines are useful when valuing assets using the cost approach.

• Use a systematic method for charging depreciation so that changes in net worth are not affected by asset market price fluctuations.
• In valuing crops and livestock, it is often difficult to determine the cost of production inputs. Use the market value minus the marketing cost.
• You can usually take the value of intermediate assets directly from your income tax records.
• In valuing real estate, do not depreciate land, only buildings and improvements.

  Some farmers use both methods of asset valuation to understand the effect of market prices and business management on the farm's solvency position. Whichever method you use, be consistent and use it for the purpose intended.

A sample balance sheet for the Whitmer farm using the market value approach is shown below:

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Types of Farm Assets

  Current farm assets. These include cash, accounts receivable and other assets that are easily converted to cash without affecting the business operation. They include prepaid expenses, supplies, crops, livestock, others, that will be consumed in production or that will be sold during the year. The Whitmer farm has $1,500 in savings and $2,200 worth of feed and supplies on hand. The farm is expecting a deficiency payment of $6,700. Soybeans with a market value of $14,500 and market hogs worth $14,000 are on hand. Therefore, the total current farm assets for the Whitmer farm is $38,900.

  Intermediate farm assets. These include those that support farm production and have a useful life of more than 1 but less than 10 years. Breeding livestock, tools, vehicles, machinery and equipment fall into this category. Unlike current assets, intermediate assets are not easily converted to cash; doing so would disrupt production. For example, machinery and equipment are harder to sell than crops and market livestock, and selling these assets may reduce farm productivity. The market value of the Whitmers' machinery is $64,800.

  Long-term farm assets. These include farmland, buildings, improvements and items that have a useful life of more than 10 years. These assets are diff icult to convert to cash, and doing so would seriously affect farm production. The Whitmers own 100 acres, including a house and farm buildings, valued at $250,000. Another 450 acres are rented but these are not assets of the Whitmer farm so they are not listed on the balance sheet.

  The sum total from each farm asset category are added together for the Whitmer farm. The Whitmers have a total farm asset of $353,700.

  Nonfarm assets. This is another section included on the asset side of the balance sheet. For many farmers, personal items such as a home, furnishings, vehicles, others, are considered part of the farm operation. If they are not included in the farm asset categories, they may be included in the nonfarm asset section. However, some individuals choose not to include personal items in the balance sheet. In this case, the nonfarm asset section would be left blank. The Whitmers list their home as part of the farm assets in the long-term farm asset category because it is difficult to list the value of the house separately from the value of the rest of the farm. However, they list other personal assets in the nonfarm asset category. The total is $20,200.

  The bottom line on the asset side of the balance sheet shows the Whitmers' total assets - $373,900.

Types of Farm Liabilities

Current liabilities. These are debts due in the coming business year. They include your farm accounts payable and accrued expenses such as rent, interest and taxes. Short-term notes such as those you use to cover operating loans and the principal on longer-term liabilities due within the next year are also listed in this category. These liabilities correspond somewhat to current assets since funds needed to make payments on these liabilities may have to come from liquidating current assets. The Whitmers owe $350 to the local oil company. They list interest they owe for their operating loan ($450), machinery loan ($450) and farm mortgage ($6,500). In addition, they owe $11,250 in principal on an operating loan. In the next 12 months they will pay $3,500 on their machinery loan principal and $2,900 on the farm mortgage principal. The Whitmers estimate that they owe $1,500 in contingency income tax liabilities (see section on contingency taxes). Their current farm liabilities total $26,900.

Intermediate liabilities. These include liabilities that will be repaid from 1 to 10 years from the date on the balance sheet. Loans for breeding livestock, machinery and equipment are typical of this category. Do not double-count liabilities by including the current principal portions of these liabilities that have already been included in the current liability section.

Intermediate liabilities correspond to intermediate assets since the intermediate assets will generate the income needed to make the payments on these liabilities as they come due. The Whitmers owe $13,500 in machinery loans. This does not count the $3,500 that they will pay on the loan principal the coming year. The Whitmers do not list any contingency taxes since they estimate the market value of their equipment to be about the same as their book value (see contingency tax section).

Long-term liabilities. These consist of mortgages and contracts owed on farmland and loans for buildings and improvements. These liabilities have payment due dates beyond 10 years. These liabilities correspond to long-term assets. The long-term assets will generate income needed to make payments on these liabilities when they are due. As with the intermediate liabilities, the current principal portion of these loans that are included in the current liability category should not be entered here. The Whitmers; owe $85,800 on their farm mortgage. This does not include $2,900 that they will pay on the loan principal this coming year. The Whitmers calculate their contingency tax on the increased value of their farm to be $14,000 (see contingency tax section).

The sum totals from each farm liability category are added up for the Whitmer farm to get total farm liabilities of $139,400.

Nonfarm liabilities. These should be listed if nonfarm assets were listed on the asset side of the balance sheet. The Whitmers list $3,550 owed on an automobile loan. This is added to their overall farm liabilities to get a total liability of $142,950. This figure is then subtracted from total assets to calculate a net worth of $230,950 which is the bottom line on the right-hand side of the balance sheet. The Whitmers could also calculate a farm net worth by subtracting total farm liabilities ($139,400) from total farm assets ($353,700) to get $214,300.

Contingent liabilities. Consider this type of liability in formulating your balance sheet. These liabilities are contingent upon the sale of your assets. Sales of crops and livestock listed in the current asset category may generate a profit on which you have to pay income taxes. An estimate of these taxes should be included in the current liabilities on the balance sheet.

Your intermediate- and long-term assets such as machinery, equipment, land, buildings and improvements often have higher market values than the book values of these items used for taxes. If you were to sell them, you would have to pay a tax on capital gains. Estimate these contingent taxes and enter them on the balance sheet as liabilities. This is particularly true when you value your assets using the market value approach. When using the cost approach, you usually use the book value for taxes to value the assets making it unnecessary to consider contingent tax liabilities. Estimating contingent tax liabilities is sometimes difficult, especially with constantly changing tax laws. Recent tax guides will provide you information on capital gains tax rates. Also, professional accounting or tax services will be able to help you.

Diagnosing Debt-Related Problems

  The fact that the liability categories correspond to the asset categories is another useful feature of the balance sheet. Comparing debts with their corresponding assets can indicate potential problems. Comparing current assets with current liabilities can tell you something about the liquidity or cash flow of your farm operation-its ability to generate enough cash to meet financial obligations when they are due (see Fact Sheet 541, "Assessing and Improving Your Farm Cash Flow"). The current ratio is calculated as:

  A current ratio of less than 1 would indicate a potential cash flow problem, while a current ratio greater than 1 would indicate enough cash on hand to meet current obligations.

  Similarly, you can compare intermediate liabilities and assets. While your intermediate liabilities rarely exceed your intermediate assets, there should be an ample margin to prevent future cash flow problems.

  Farms that have low current ratios (indicating cash flow problems) or high intermediate debts may consider refinancing them as long-term liabilities. However, this is an option only for farms that have longterm assets that exceed long-term liabilities.

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