Written by Dr. David Kohl
The traditional image of the American farmer often includes owning the land passed down through generations. Yet today’s agricultural landscape tells a different story. A major trend in agriculture since World War II has been the shift from asset ownership to asset control. In the earlier era, less than 20 percent of agricultural assets were rented or leased. Today, that figure stands at approximately 60 percent. Whether land, facilities, equipment, machinery, or even livestock, short-term and long-term rental and lease agreements have become a common mode of operation. Agricultural businesses in the start-up, growth, or transition stages often rent or lease operational assets, much like many small non-agricultural businesses do.
When legacy capital and equity (specifically land) represent a smaller portion of the balance sheet, the dynamics change. Without substantial owned assets as backup for refinancing or leverage for growth, business and financial risk management takes on new dimensions. This raises an important question: What prudent practices are necessary not only for survival but for prosperity, both short-term and long-term, when legacy wealth is minimal?
Focus Group
Recently, I had the opportunity to work with a spontaneous, informal group of producers and lenders to explore best financial and business practices for operations that rent or lease the majority of their assets. These businesses often have not had time to acquire, build, or inherit legacy wealth in the form of land appreciation that could provide leveraged growth opportunities and security for lenders.
Both groups shared a striking consensus: high debt-to-asset ratios, which national media and policymakers frequently cite as indicators of financial stress and risk, are not actually lead indicators. Instead, this metric, along with bankruptcy and loan defaults, functions as a lag indicator. These measures trail well behind the true warning signs of trouble, which are issues with profitability, cash flow, and loss of financial liquidity. These factors generally serve as the real lead indicators of financial distress.
Prudent Practices: Earns and Turns
A producer who rents or leases a significant amount of capital assets must focus on earned net worth. This takes precedence over paper wealth or
appreciation from inflation of land values and other assets on the balance sheet.
Building earned net worth requires a focus on profitability and cash flow through what we call “earns and turns.” The concept is straightforward: net
income margin (revenue minus all costs) multiplied by capital turnover (the number of times the business turns its assets). For example, if a business has a net margin of 6 percent and a capital turnover of 1.5 (revenue divided by assets), the return on assets would be 9 percent.
Improvements in net margin can quickly change the profit equation. These improvements might come from executing a marketing plan, managing costs, growing revenue, or eliminating inefficient assets. On the flip side, any macroeconomic pressures or management missteps that reduce margin or slow capital turnover will reduce the return on assets and diminish cash flow.
Profit Management and Building Financial Liquidity
Various agricultural sectors experience short-term and long-term profit cycles, as the beef industry is currently demonstrating. At the top of the cycle, it is critical to have a deliberate profit plan. Consider the60-30-10 rule: allocate 60 percent of bottom-line profit to improving efficiency first and growth second. In other words, get better before you get bigger. Next, dedicate 30 percent to building financial liquidity in working capital. This becomes your backup for adversity or growth when you do not have land equity. The remaining 10 percent of profit can be used at your discretion for business, family, and personal goals.
Risk & Marketing Management
A sound risk management and marketing program is
critical for those without legacy capital. Crop insurance, livestock insurance, and other coverage options can be purchased to reduce losses and protect working capital. A marketing plan that emphasizes accumulating base hits rather than swinging for home runs often provides the foundation for building earned net worth overthe years. An old saying in marketing rings true here: you will often leave money on the table when you balance opportunity with prudent risk management.
Cost of Production
A simple spreadsheet can be used to monitor the cost of production by enterprise. One producer in the focus group tracks costs by individual field and livestock enterprise. Monitoring cost of production is critical in land and lease negotiations, particularly in a competitive marketplace. A monthly or quarterly cash flow statement that is tracked and communicated with the lender and other stakeholders proves crucial for both short-term and long-term capital investment decisions.
Family Living Cost
Modest family living cost withdrawals are an important element in building earned net worth. Avoiding or minimizing the purchase of shiny new toys
during good economic times is a prerequisite for resilience in the down cycle. When controlling assets rather than owning them, using capital and human resources to improve efficiency, agility, and nimbleness proves far more valuable than investing in nonproductive assets. More young and beginning producers are separating their business and family living budgets as a best management practice and for greater transparency in the business.
The Bottom Line
When all is said and done, a business without a large amount of legacy capital requires above-average management in many areas, including production, operational efficiency, marketing, and risk management. Organized financials that are executed and monitored can place the odds of success in your favor when you do not have substantial legacy capital.
