Four Ways To Prepare For Downturn

No. 1 step is to have 25%-35% of revenues as working capital.

Published on: Jul 12, 2013

Lynn Paulson, senior vice-president of Bell State Bank and Trust, Fargo, N.D., is bullish on farming and ranching.

"I believe the long-term trend in agriculture is still very favorable and positive," writes Paulson, in one of the bank's recent newsletters. Bell State Bank increased its ag related loans by more than $100 million in 2012, 

"However, I do think there will be significant volatility swings within this favorable long-term trends," he says.

To cope with the volatility, Paulson offered some advice in the newsletter. It included several tips, including:

•Have enough working capital. "It's the "shock absorber" to cushion the impact of economic downturns that inevitably will come," he writes. "It preserves profits before you tap into hard equity," he says. One general rule of thumb is that 25% to 35% of farm revenues as an acceptable working capital position. If your operation grosses a million dollars, a minimum working capital level under this scenario would be somewhere between $250,000 to $350,000., he says.

Four Ways To Prepare For Downturn
Four Ways To Prepare For Downturn

•Be able to borrow against fixed assets. Farmers generally don't view cash as a good asset, Paulson notes. As a result, much of their profits are locked up in fixed assets.  "Ideally, they should be able to borrow against those assets in economic downturns to bridge working capital shortfalls, but conditions at that time will dictate," he says. "Also, farmers in general don't like paying excessive income tax. As a result, there are some operations that may be over-equipped as a result of equipment purchases made to minimize income taxes. There's nothing wrong in doing this, but it may have some ramifications down the road when economic times aren't as good as they've been"

•Manage land investments carefully. "On average, 85% of a farmer's asset base is in land. That can make for some pretty significant market-based owner equity swings when land prices are volatile. We typically chose not to chase those values up or down on our financial statements. We're concerned with earned equity – not market appreciation or asset revaluation increases in equity. We like to see balance sheets built on profits, not market appreciation.  In this environment of very high land prices – fueled by high commodity prices – one needs to be vigilant and cognizant about growing a farm dramatically through land purchases. Clearly, there are good reasons to pay up for land. Land that lies right next to a parcel that you already own – or land that you might only have one chance to purchase – are good reasons to take a run at buying, if you can afford it and the rest of your operation can subsidize it in average economic times."

•Be realistic in your income and costs projections. "A recent study showed that on average, producers overestimate cash receipts by 15% and underestimate expenses by 17%....Overall, it may be prudent in the coming years to expect to pay 10% more out of cash flow due to increasing taxes," Paulson writes.

Source: Bell State Bank