Written by Dr. David Kohl.
The turbulent economic times appear to have no end in sight. Rising inflation, central banks around the globe increasing interest rates, geopolitical tensions, and weather are just a few of the contributors to a challenging economic environment. As a veteran of the 1970s and 1980s, I often encouraged borrowers and lenders to work side-by-side to navigate the choppy economic waters. It seems that 2023 and beyond will be similar economic times. Let’s examine some of the elements that go into a borrower-lender playbook to build resilience and agility to capitalize on opportunities.
Your first action should be to ensure accurate and updated financial statements, including a balance sheet, cash flow and income statements, are completed. The key moving forward will be to monitor these statements quarterly, monthly, or, in some cases, more frequently depending on the type of business. Inflation and volatility add to abrupt changes in prices, costs, and interest rates. A projected cash flow that is compared to actual results can be a good tool to develop strategies for adjustments in marketing and risk management programs and operational planning.
Your lender and other key advisors, such as a livestock or crop consultant, can provide input, guidance, and another look at business performance. A third-party perspective can provide a more objective approach to decision making in an economic environment that can become very emotional.
Financial stress testing provides parameters or guardrails of possible outcomes. A good set of spreadsheets with production, cost, price, and interest rate assumptions needs to be focused on for 2023. It appears that some inflated costs will remain the same or slightly increase such as fertilizer, fuel, and labor costs. One must also plan for possible shortages and develop plans B, C, and D to assess the impact on production and overall operations.
Some producers are financially stress testing at the field level, not just the farm level. This can be invaluable in determining which resources to continue or eliminate in the production model. Knowing your cost of production and breakeven points at this level or via enterprise can provide the playbook for allocating capital and labor to its highest and best use. Sometimes resiliency and agility are not about adding or growing but can be discontinuing or scaling down.
What price can you accept or be willing to pull the trigger on to execute your marketing plan? Remember, the most profitable managers often leave some money or profits on the table and “fail fast” or move on from the decision.
To build resilience and agility, financial benchmarking is an important action in the financial playbook. One needs to compare your results year-over-year and over the past three years to projections. The following are a few of my favorite ratios monitored in our business and utilized in the industry.
Term Debt Coverage Ratio
The term debt coverage ratio indicates your ability to service debt. To calculate this ratio the sum of net farm income, nonfarm income, interest expenses, and depreciation expenses minus living expenses and income taxes is divided by the sum of your total principal and interest payments. A three-year average or projections above 150 percent could represent both resiliency and agility. A term debt coverage ratio less than 120 percent indicates vulnerabilities.
Current ratio and working capital to expenses
Working capital is the backup to cash flow and profits. Strong working capital is indicated by a current ratio greater than 1.5 and working capital to expenses exceeding 25 percent. How quickly the working capital can be converted to cash will be another key in evaluating agility.
Term Debt to EBITDA
Term debt, which is non-operating debt, divided by EBITDA* measures the extent that earnings can service your amortized debt over a period of time. In your analysis, calculate a three-year average plus projections. If this ratio is less than 3:1, you are fairly resilient and agile. A term debt to EBITDA ratio between 3:1 and 6:1 indicates some caution. When this ratio is greater than 6:1, your business might be vulnerable given these uncertain times.
What is in your playbook for resilience and agility in 2023 and beyond? Perhaps some of the points and perspectives from this article can be new additions to your playbook when working side-by-side in the borrower-lender relationship in 2023 and beyond.
*EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization
Dr. David Kohl energizes agricultural lenders, producers and business professionals with his keen insight into the agricultural industry through extensive travel, research, and networking around the globe. He is a Professor Emeritus of Agricultural Finance and Small Business Management and Entrepreneurship at Virginia Tech, Blacksburg, VA. Dr. Kohl has traveled over 8 million miles in his career and conducted over 6,000 workshops and seminars for a variety of agricultural audiences. Additionally, Dr. Kohl’s personal involvement with agriculture provides a unique perspective into the future trends of the agricultural industry and economy.
