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The equity in your business

15/02/2005


It is generally understood that there is a relationship between risk and return. Unfortunately, the relationship is not always positive because losses can occur. For a lot of farmers, 2004 was a very good example and with prices where they are, 2005 could be somewhat bleak as well. But it is early yet! As they say, no crop was ever lost in the winter!

The theory is that the return should be greater when there is greater risk in the business. Personally, I think that farmers generally accept a relationship between risk and return that the majority of people would not. There are lots of reasons for this, the bottom line of which is for many farmers, notwithstanding the economics, a genuine love of the business.

The return to labour and management, which refers to a return to the time you spend, working in the business and to the investment you have in the business, is usually measured in terms of money. The money you receive as a salary or draw is the most tangible. The other return is less tangible but it exists nonetheless and that is the increase in the equity you have in the business. Most everyone is familiar with the ‘farmers live poor and die rich’ scenario. This refers to the growth in equity over time that is converted to more liquid funds and triggered by a sale, usually at retirement. Increases in equity come from net earnings and from increases in asset values. Conversely, decreases in equity come from losses and decreasing asset values, such as falling land values.

Decreasing Equity

Obviously, the scenario where your equity is decreasing should be reason for concern. There are some actions that you should undertake in this scenario. Firstly, and this may appear somewhat obvious, farmers should be aware that it is happening in the first place. And secondly, farmers should know whether it is a one-time event or a multi-year trend. The latter is the more serious of the two.

The most common legal operating structures for farmers are sole proprietorships, partnerships and corporations. If your business is incorporated, you will probably receive a set of financial statements as prepared by an accountant. These statements will include a balance sheet that reports fixed assets (land, buildings and equipment) at original cost less accumulated amortization. In this situation, any loss in equity comes from operating losses. A decline in land values for example, will not be reflected. Nonetheless, if land values have eroded, your ‘equity’ in the business has decreased. So, it is important to annually calculate your net worth. The equity should be expressed in terms of net worth. Net worth is the difference between assets and liabilities and refers to equity in the business that factors in the market value of assets.

If you are incorporated and receive an accountant prepared balance sheet, simply make an adjustment for the market value of fixed assets.

There are numerous farmers who are either sole proprietors or are in a partnership who do not annually complete a statement of net worth. Unless a lender insists, there is no requirement to have it done. This is concerning as it is not possible to quantify or measure the dollar value of any decrease. A farmer may in fact be well aware that land values, for example, are declining, but he or she will not be able to measure the impact without completing a statement of net worth and calculating some key ratios. It is critically important that this be done annually so that trends can be determined. It is far easier to fix a problem early on than it is to after a trend has developed.

Lenders

Farmers have told me on numerous occasions that their lender does not require that they complete a statement of net worth. There are a couple of issues here. Firstly, there are lenders who do not ‘require’ that the farmer complete a statement of net worth. Their institution actually requires that such a statement completed and included in the files, but they gather the information from the farmer and complete and analyze the statement themselves. If the lender is telling you that he or she does not require that you provide them with a statement of net worth, ask them if they have one on file. If so, ask for a copy. You are entitled to receive a copy.

The situation exists as well, where the lender does, in fact, not actually require a net worth statement. The reason in virtually every instance is that the farm is not carrying much or any debt. But if you are in the favourable position whereby you have little or no debt, should you not be equally concerned about decreasing equity and if so, should you not be annually calculating your equity and analyzing what’s happening to it? If you have an investment in a mutual fund, do you not look at the increase or decrease in the fund’s value? Most people I know do, and this is no different than looking at what’s happening to the equity in your business.

The Impact When Equity is Decreasing

Equity can erode for several reasons. I am going to focus on just a couple. Firstly, when analyzing your statements and determining that your equity has decreased, check to see what is causing the problem. Look at the relationship between current assets and current liabilities. Equity can erode because of a poor crop and/or poor prices. Prices and yields of commodities usually have the most immediate impact on equity. Where the price and yield mix is severe enough to result in an operating loss, equity decreases. Any decrease in equity caused by poor yields and prices is usually factored in the shorter term. This happens in grain farming. Farmers accept and insure against, as much as possible, this risk and manage their business with the belief that events cycle and there will be an improvement from poor performance.

In this situation, the impact is on cash flow and the availability of the operating or working capital farmers need to manage their businesses. In some situations, the circumstances can be extreme enough that a farmer cannot arrange sufficient capital, or cash, to operate the farm. This is usually because a lender and/or input supplier cannot justify the extension of credit.

It usually takes a series of ‘bad crops’ to have any longer term impact on fixed asset values, for example where land values decrease and equity is eroded. As mentioned, this scenario usually takes more time to occur but when it does, the situation is not good. For a farmer with no or little debt, this is only a problem when a sale occurs. And it is only the farmers who do actually sell who are confronted with the impact on their equity. But unfortunately, it is often a series of losses that triggers the decision to ‘get out’. The decision is very tricky. No one actually knows if things will turn around, or when. How long a farmer hangs on can depend on many circumstances.

For farmers who are quite leveraged, a decrease in equity due to decreasing land values, for example, can have serious implications on debt to asset ratios and ultimately on lender confidence in their operation, and in the whole sector. A deterioration in lender confidence is usually expressed by either an increase in the cost of borrowing, limited availability of credit or in the worst case, not providing credit at all.

Any situation where there is an erosion of equity is not good. It has been a long time since there has been any widespread and long-term erosion of equity to decreasing land values. But it is something that can happen. What to do? Firstly, farmers should complete their statements of net worth and look at what is happening to their equity and what the causes are. Secondly, they should consider what options they have to make improvements to change what is happening. Thirdly, they should talk to their accountant, a farm management specialist and their lender. These people can be an excellent resource when a farmer is faced with a really challenging and stressful situation.

Farmers work too hard and accept too much risk to not do what they can to protect their equity. 

By Terry Betker, Director, Agriculture - Industry & Government. Originally published in the Saskatchewan Canola Growers Association Newsletter (March 2005). For more information, contact your local MNP advisor or Terry at 204.788.6055.