Last month I wrote "Should I Buy Land Or Rent It?" You'll recall I recommended buying rather than renting if your financial condition can stand another purchased farm and still retain the needed "shock absorbers" to withstand adversity.
The advantages of buying land are stability of farming base and a good return as well as a good long-term investment. The downside is it ties up a lot of capital, reduces your flexibility for making other investments and reduces your cash flow during the early years of ownership.
Your most important financial shock absorber is working capital. It eases the pain on the operation if a financial "bump" in the road comes along. Of all the operations I look at in a year it is generally the weakest area, yet one of the most important in overall financial survival.
A useful standard we use is the percentage of working capital available compared to your annual expenses. Working capital is current assets minus current liabilities. Expenses include all cash expenses, including living and payments.
Working capital/annual expenses should remain more than 50% after the purchase. For example, if your annual expenses are $750,000, your working capital should be $375,000. I would look at this on January 1, which is generally when last year's crop is harvested and limited expenses are incurred for next year's crop. We call 50% or better "green light." "Yellow light" would be between 20% and 50%. If your working capital after the purchase is less than 20% of your annual expenses, don't buy the farm. It could jeopardize your entire operation.
This is a standard most banks and other lenders do not use. They use a ratio of current assets to current liabilities and like to see it 2:1 or better. The problem with that is it can get distorted by timing and does not relate true risk.
I know of one case where a Missouri farmer had $100,000 of current assets after he sold his grain in the fall and had $50,000 of current liabilities, for a 2:1 ratio. However, his annual expenses were nearly $500,000. It looked good by one standard, but really wasn't.
Why is it important to have greater than 20% working capital to annual expenses? Your expenses can easily be up 10% over your projection and your income can easily drop by 10%. If you are less than 20% to start with, you could end the year with negative working capital. Most lenders say they look at cash flow rather than at equity. But in many cases, it's their regulator that has more influence when times get tough.
Farming is an industry that needs higher levels of working capital than many others because of the risks associated with weather and markets. Plus, farming is a very capital-intensive business.
But, debt is not bad. If used correctly and structured properly, debt actually enhances your return on equity. I just did a feasibility analysis for a combine purchase for an Iowa farmer. He planned to put all his money in the deal because he had the cash. I encouraged him to look at carrying debt on it and it changed the Internal Rate of Return on his cash investment in the combine from 7.37% to 12.71%.
I recall one case recently where a farmer's working capital looked weak, but he had no debt on a very large line of equipment. He restructured some of his short-term debt to his equipment line and then had good working capital. In fact, he bought the farm he was looking at after he restructured his debt. More importantly, the debt is now on a term basis rather than having it all due each year. Try to keep your entire debt-to-asset ratio below 50%.