As advisors, we see many business and farm financial statements through out the year.  Most of the successful farm businesses have several key financial ratios in common.  Even though each farm business is different, it is surprising how these ratios tend to be in the same range for each business.

These key ratios that we look at are as follows:

• Current Ratio – This is the ratio of current assets comprised of cash, inventories and receivables divided by current liabilities comprised of short-term notes payable, accounts payable, accrued liabilities and current portion of long-term debt.  This ratio determines how much of your assets will be available to pay off the debts owed over the next year.  It is important to include any long-term debt that will be paid off in the next year.  This ratio should exceed 2:1 and for most successful farm businesses, it is usually over 3:1.

• Net Worth to Debt – This is the ratio of your farm net worth divided by the total debt of the farm.  The higher the ratio the less your farm is leveraged.  Most successful farms will have a ratio that exceeds 2:1 and in most cases will approach 5:1.  A starting farmer’s ratio will usually be much lower than a long-term many generation farmer.  This is one of the ratios that bankers will always put the most importance on.

• EBIDTA – This is your farm earnings before interest, depreciation, taxes and amortization.  The reason this ratio is important is that it places each farm operation on the same level, i.e., you are able to compare a farm bought for cash to a farm bought with debt.  This will let you know for each farm or farm unit what income is being generated by the farm.  This income should always have an expense component for the farmer’s salary to make it comparable to other businesses.  The ratio of EBIDTA to net farm sales will vary greatly depending on the type of farm crop grown, but in general, we should see a ratio that exceeds 20% or more.

• Machinery costs to sales – This ratio seems to be one of the best ratios in determining how profitable a farm is.  The lower that a farm operation can keep this number, then this farm will usually end up in the upper farms in profitability.  Some farmers will lease new equipment each year while others will keep the same farm iron forever, the key is to keep this ratio as low as possible and still get the crop grown and harvested.

I have given you four of the key ratios that I see.  Have you computed yours and are there others that you use on an annual basis.  Let me know!

To maximize your profit for your farm, it is very important to determine what your annual fixed costs are and determine if you are maximizing your amortization of these costs on your farm.  Fixed costs are those costs that do not materially change with production increases and decreases. 

Some examples of fixed costs are:

• Depreciation on your equipment
• Insurance costs on equipment
• Your annual salary cost for providing services to the farm operation
• Office related costs
• Other annuals salaries for workers who are not at full capacity

These costs are mostly fixed and if you can increase your production to full capacity, these costs per unit of production will decrease substantially.  The goal is to maximize your production to equal the full amortization of these fixed costs.

Lets say you have a farm with 1,000 acres of production and your total annual fixed costs are $100,000.  This means your average fixed cost per acre is $100.  If you have enough equipment and capacity to farm 2,000 acres and all of your variable costs will remain the same, you will reduce your fixed cost amortization from $100 to $50.  This will result in additional profits to the farm operation of $50,000.

Try calculating these costs for your farm operation and see how it would effect your bottom line.

However, you also need to be careful that as you approach full capacity, you may have to make major investments to go slightly over full capacity.  This can then put your back with higher fixed cost amortization.

Marcia Taylor with DTN/The Progressive Farmer had a great post recently on the elimination of crop insurance under the Group Risk Income Protection (GRIP) and Group Risk Program (GRP) in over 1,000 counties across the US.  The primary reason for eliminating these counties were due to not reporting at least 30 yield reports or 25% of the acres for the county.  The USDA requires at least this amount of data in order to provide the insurance coverage.

Also, of the 1,062 counties that lost these insurance programs, only 310 counties were actually buying these types of insurance policies.  It appears that most of the counties affected were located in the South, Great Plains and Eastern part of the US.  Most the Mid West corn belt was not affected.  The decision eliminates this coverage for corn, soybean, grain sorghum, cotton and peanut producers.

Farmers in Lawrence County, Alabama say their maximum insurance yield reduced from 135 bushels per acre to only 60.  This insurance can be expensive.  GRIP with a harvest-price option cost $90 per acre as mentioned in the article, however, the return has been as high as $415 in 2007 and $222 in 2008 per acre for this particular county.  Payouts were as high as $614 per acre in Baca County, Colorado in 2008 largely due to the steep decline in corn prices.

However, these farmers need to realize they need to report their yields and if they do a good job of this, then the coverage will be available again.  The trends over time have shown that this coverage returns about $1.78 for every $1.00 of premium. 

GRIP has offered some of these growers superior coverage levels.  This coverage is no longer available and it may cost the farmers substantial losses to their bottom line.

Does the recent announced closing of the hog plant located in Sioux City, Iowa mean that hog prices will increase during 2010.  First, the closing will directly impact 1,500 workers and their families in the area.  Some of them may find work at other plants located in the area, but many will need to find new jobs which is tough in this still weak economy.

The Iowa Farm Outlook published a post on the expected impact in the area due to the closure.  The Sioux City plant processed approximately 4 million hogs each year and this is almost equal to the expected decline in hog production from 2008 to 2010.  Since this should more closely match hog processing capacity to production, this should result in an increase to hog prices in 2010.  Prices have already increased substantially from their early 2009 lows, but have much farther to go to get back to their highs.

I have posted before that hog farmers were probably losing at least $20 per hog grown in 2008 and 2009 due to high feed costs and low prices (part of it due to the Swine flu scare).  I believe that hog farmer profits in 2010 will be positive and if feed prices decline, they may make very good profits.

Although one plant is closing in the area, there are another 7 plants within 100 miles that process over 28 million head per year.  This is certainly an area with more hogs than people.

I am a firm proponent of using hedges to lock in your cost of production when you can.  However, you must not just look at what your commodity price is trading at on the relevant exchange.  You need to determine what your basis is and how it compares to the historical trends.

Basis is the difference between what your local elevator, ethanol plant or other buyer is willing to buy your crop for and what the price is on the exchange.  For example, assume you can sell your corn locally for $3.85 per bushel and on the exchange it is selling for $4.25.  Your basis is in this case a negative 40 cents. 

For growers that are far away from the end user of the product, their basis is normally quite negative compared to other growers.  This is due to the cost of shipping the product to market.  A grower with several ethanol plants competing for product will normally create the best basis for corn growers (in many cases you will have substantial positive basis, while a wheat grower in Montana that has to ship his product by rail to Seattle to ship it overseas will have a very negative basis).

After determining what your basis is, you need to review how the current basis compares to the trends over the last several years.  This comparison of the deviation from the normal trend will give you data as to whether you expect it to narrow toward or away from the exchange price.  This can effect whether you want to put on a hedge or use some type of forward contract.

The Kansas State University has a great Crop Basis and Deviation service that they provide on an almost weekly basis.  They provide a map for several mid-west states showing the current basis and the deviation from a three year average.  If you are in one of those states, bookmark this site and watch how your basis changes over time.   

As you become familiar with your basis, you will make more informed decision when and how to sell your crop.

All in all, farm debt levels have increased, however, farmers have done a very good job of not letting these levels get out of control.

The United States Department of Agriculture has a very good print and online magazine called Amber Waves.  Each issue generally has several good articles related to farming and I would highly recommend reading it each month.

In the December issue, the an article on how farm debt has increased and shifted in the last few years was highly informative.  Here are the highlights of the article:

• Farm debt levels have risen sharply in recent years, but the growth in farm asset values has outpaced the growth in debt. 
• Fewer farms end the year with debt outstanding than in the past; debt is more concentrated in larger farms
• Debt repayment capacity is expected to decrease this year, but remains well above levels seen in the later 1970s and early 1980s

US farm sector debt was estimated at $240 billion at the end of 2008, however it is expected to decrease by about $6 billion to $234 billion at the end of 2009.  Total farm assets are estimated at about $1.8 trillion for a debt to asset ratio of only 13%.  This ratio is about 2.7 times better than the low reached in the mid-1980s farm crisis.

In 1986, nearly 60% of farms reported having outstanding debt at the end of the year; by 2007, this figure had dropped to 31%.  Larger farms are more likely to use debt than smaller farms.  The majority of small farms indicated they have sufficient liquidity to finance their operations.  Livestock operations tend to have higher levels of debt than crop operations.

At the end of 2007, 65% of farmers reported having no outstanding on their business balance sheet, however, these farms only average about 258 acres in size.  14% of farms reporting between $1 and $5 million in sales also reported having no debt outstanding at year-end.

Farms that reported having multiple loans with multiple lenders only represented 6% of farms, however, they had more than 31% of total farm debt outstanding.

Farm debt has increased more slowly than income.  As a result, the ratio of debt to income has trended down from a ratio of five times annual farm income to less than three times annual income in 2007.

Debt repayment capacity utilization (DRCU) measures debt obligations in relation to maximum debt repayment capabilities.  The lower the DRCU number the better.  This measure has decreased from 27% in 2007 to about 18% in 2008.

 Most ag grain producers are able to lock in prices by using either a hedge or a forward contract.  Forward cash contracting involves a commitment to deliver grain to a grain buyer at a future time.  Both alternatives can be used to: price before and after harvest; establish a return for storage of grain; and reduce price risk.  Thus, deciding which alternative to use depends upon weighing hedging advantages and disadvantages in comparison to forward cash contracting.

Hedging Advantages vs. Forward Cash Contracting

• Hedging allows flexibility to later select the appropriate delivery point to take advantage of competing buyers for your grain.
• Hedging allows you to reverse a decision based upon changes in growing conditions, changes in price outlook and changes in the condition of stored grain.  Once a forward cash contract commitment is made, it is very difficult to change or cancel.  A position in a futures contract can be terminated almost immediately.
• Hedging allows the farmer to speculate on basis improving.
• Hedging generally lengthens the potential pricing period to 20 to 24 months, including about one year before and after harvest.  This can be longer than a forward cash contract.

Hedging Disadvantages vs. Forward Cash Contracting

• In hedging, you may not know the final price due to changes in the final basis as compared to the initial basis.
• Hedging is more complex than forward cash contracting.  To hedge successfully, a farmer must understand futures markets, cash markets and the basis relationships between the two markets.  They must trade in a futures market and involve a commodity broker and have a banker who understands and is committed to hedging.
• Margin money is required to maintain a futures position.  A forward cash contract typically does not involve margin deposits.
• Hedging involves commissions and interest on margin money.  These extra costs may average 1 to 2 cents per bushel.
• Since hedging generally involves using future contracts in either 1,000 or 5,000 bushel lots, the farmer is locked into these quantities to hedge.
• Basis levels may not gain as expected and can even widen more than expected.

Remember that hedging never guarantees a profit.  The hedging decision needs to take into account production costs and market outlook.  However, the good use of a hedging program can help the farmer prevent pricing indecision where the farmer “does-nothing-until-forced-to-sell-strategy” which normally leads to much lower prices.

 Most farmers are of an independent nature, however, in one area they may want to consider partnering up on is grain storage.  The decision to build on-farm grain storage can be very complex.  Farms that are mid-size or smaller usually find it cheaper to continue to bring their grain to an elevator versus storing it on their farm.

However, if their are several compatible farm operations in a central location, the idea of Condo Storage may make a lot of sense.  The benefits are that instead of each farmer having to spend the same amount on certain items related to the storage facility that cost the same whether they build 5,000 bushels or 500,000 bushels, they may be able to pool their money together and only spend it once. 

Most of these condo storage operations have employed a farmer-owned LLC.  The farmer buys shares in the limited liability company and receive rights to store grain in proportion to the amount of shares owned in the LLC.  The storage structures and equipment are owned by the LLC, not the farmers.  This provides liability protection for the farmer investors.  If somebody were to get injured (or even die) working in the storage facility, the only asset at risk are the assets of the LLC, not the farmers assets.

The LLC then depreciates the structure and equipment and passes the depreciation back to the owners based upon their ownership percentage.  Also, the Condo LLC may charge each farmer a per bushel fee to store the grain and then the net income or loss is allocated to the farmer owners.   If a fee is charged, this allows the LLC to offer its storage to other farmers that are not owners of the LLC.  This can either help it make a profit or reduce the overall cost to the owners.  There is typically a board of directors elected to govern the LLC and make decisions regarding the assets it holds.

If the farmers do not want to manage the storage facility themselves, they can contract with a local grain cooperative to manage and run the facility for them.  Long-term lease options are also available under this structure.  To entice a local cooperative to get involved, several hundred thousand bushels of storage will probably need to be committed to the condo program.

I believe that many mid-size farmers should look into this opportunity especially with long waits and long travel times to get to grain elevators these days.

This type of condo project probably has returned a much higher rate of return than buying a Florida condo in the last few years.

Chuck Schwartau of the University of Minnesota Extension Service has a great post of how the trend in milk prices has changed over the last several months.  It is no secret that dairy farmers having been hurting for close to a year now and a common statement was “If milk was at $15,00 per hundredweight, we’d be in good shape”.  During this past year, it seemed $10 was much closer than $15.

Well, the trend has changed.  In past few weeks, there have been several opportunities to contract for Class III milk at the $15 range for January and February delivery.  Chuck indicates that milk has only been over the $15 level about 10% of the time, so make sure to take advantage of these prices now.

One option is to use a Put as insurance.  This locks in a floor price, with the price you pay for the put being your insurance premium.  These contracts can be costly, but if you have premium milk, it may be worth locking in the floor price.

A dairy farmer can also use contracting services if they belong to a cooperative.  It appears that profitable dairy farming is here and you need to take advantage of it while you can.

I was traveling over the last couple of days to the Mid-West.  I spent part of my time driving from Kansas City to Davenport, Iowa and then from there to Hannibal, Missouri and then back to Kansas City.

 While on this trip, I noticed that there was still a lot of corn that was not harvested.  Most of the farms that I saw with un-harvested corn appeared to be smaller farms since the combines were much older and only had a 4 or 6 row head.  With the weather delays, this does make sense to me since the newer larger combines can harvest a lot more acres in a day than the older machines. 

This seems to confirm the recent USDA report that indicated the corn harvest was only 88% complete.  This means that about 12% of the crop still needs to be harvested.

I am guessing that harvest will not get finished until sometime in early 2010.  I have a feeling this will go down as one of the latest harvests ever.