Gearing up for another year? FCC Ag Economics wants to pump up your farm financial fitness. Throughout March, we'll be sharing posts to help put your 2017 farm financials into a larger context. We'll also makes sense of key financial tools as you go. Check back weekly to see where Canadian ag is going and how you can stay ahead.
Building an agricultural operation requires a lot of work and capital. Elevated farm asset values may pose a challenge in an environment challenged by production, marketing and financial risk, especially so for young producers.
This post examines Canada’s farm asset values – how debt has been used to finance these assets and how profitability has supported Canadian asset values over the last five years. We’ll compare them to assets in the U.S. to understand the financial health of each country’s farm economy, and how they’re expected to trend in 2017.
Canadian asset values outpace U.S. growth in assets
Asset values in Canada have climbed each year over the last five, and they’re expected to continue climbing in 2017, an indication of a healthy farm economy. A large portion of that increase is tied to land which typically accounts for a majority of all Canadian farm assets (see our 2015 Farmland Values Report). A big driver of recent land purchases was the increase in farm cash receipts, once again higher than the five-year average. The recent period of low interest rates also helped.
Preliminary research shows debt grew in Canada close to 7% in 2016 and should grow between 3% and 5% in 2017. Those increases result from expected growth in farm asset values in 2016 and 2017. Asset values climbed faster than debt up to 2015, when the trend reversed. In both 2016 and 2017, debt is expected to grow faster than assets.
As a result, Canada’s debt-to-asset ratio has averaged 15.6% between 2011 and 2015, and should increase slightly in 2016 and 2017. This ratio shows the extent of the Canadian ag sector’s financial leverage: roughly $16 in overall debt has been used to finance $100 in total farm assets.
An operation funding its assets with more debt than equity runs a greater risk of insolvency, or not being able to pay back its debts. This can become a problem when cash flows are subject to pressures, or more generally, if interest rates increase.
How it works
A low debt-to-asset ratio provides flexibility:
- To extend terms on existing debt when profits and repayment capacity are tighter.
- To borrow more money if an opportunity shows up.
Canada and U.S. debt-to-asset ratios: How do they stack up?
In 2017, U.S. asset values are expected to drop for the fourth straight year, driven in large part by expected declines in land values in 2016 and 2017. Debt has outgrown asset values in the U.S. since 2012, when their debt-to-asset ratio hit its low of 11.3%. The ratio has climbed slightly, showing U.S. agriculture was leveraged at about 13% in 2016, expected to grow to 14% in 2017.
The debt-to-asset ratio is key to monitor as it can foretell difficulties in debt repayment. Concern about Canada’s ratio appears at this time to be unwarranted. There may have been a larger spread between Canadian and U.S. ratios in the past, but these differences have often been rooted in the underlying characteristics of each country’s agriculture industry, and not necessarily in individual producers’ financing decisions.
Included among the drivers of the differences between Canadian and U.S. debt-to-asset ratios:
- Canada’s colder climate and shorter growing seasons require different types and scales of investments to house livestock and farm the land.
- Canadian producers who own a larger proportion of farmland (and therefore need more debt to finance it) compared to those in the U.S. where land rental contracts are more prevalent.
- U.S. farms’ greater vertical integration which leads to less debt being reported and better financial ratios. Many U.S. producers don’t finance input purchases using standard lines of credit.
Despite Canadian agriculture being more highly leveraged than U.S. agriculture, other measures of its financial health show a relatively strong performer able to withstand a downturn.
Net cash income: A tale of two countries
Having the cash available to make investments or withdrawals comes from farm cash receipts. Net Cash Income (NCI), or receipts minus operating expenses (which includes debt repayment), has differed between the two countries recently. NCI began to decline in the U.S. in 2013, falling 22.7% by 2015. The USDA estimates it declined another 10% between 2015 and 2016.
Canadian NCI showed positive growth from 2013 to 2015, with an 11.5% increase in 2014 and 8.2% growth in 2015. The depreciation of the loonie was instrumental in the different outcomes, with a major plus for Canadian profitability. Estimated Returns-on-Assets for both countries shows the importance of Canada’s stronger NCI.
The returns-on-assets (ROA) indicates how profitable a company is relative to its total assets. It reflects management’s efficient use of its assets to generate earnings.
Statistics Canada calculates ROA by dividing NCI (as a measure of annual earnings) by its total assets in a given year. We calculated the U.S. ROA using the same methodology.
Canadian and U.S. trends in profitability: Who has more financial flexibility?
Both Canada and U.S. ROA declined over the five-year period (2011-2015). Canada’s returns showed a slower rate of decline, due to both Canadian asset values which continued to increase over the five years, and to increases in net cash income (NCI) U.S. producers didn’t see. A combination of falling net income and falling asset values in the U.S. meant that, by 2015, U.S. returns-on-assets had fallen more sharply than Canadian profitability: the U.S. ROA fell by one-third while the decline in Canada ROA was less than 10%.
3 key takeaways
- Both Canadian and U.S. agriculture show low leverage and the ability to weather a downturn in the farm economy.
- The debt-to-asset ratio is a secondary measure of the ability to repay debt because it measures solvency after assets have been liquidated. The primary measure of solvency is always income. A low ratio indicates the flexibility needed to refinance debt if lower cash flows or earnings make debt payments difficult.
- Financial risk isn’t shared equally among all farm operations. Looking at Canada’s aggregate measure of leverage hides the number of operations that carry high leverage. Know your financial ratios. We’ve provided several resources here, but another great option is your accountant or an FCC Relationship Manager.
Stay tuned for our next blog posts. We’ll look at two more measures of Canada’s farm financial health: the cash flow available to meet debt obligations and the working capital used to buffer operations from unexpected cash shortfalls.