Case Studies

The best way to learn how to identify, evaluate and manage agricultural risk is to apply what you’ve learned to real life farming scenarios. Test your risk management critical thinking skills by choosing a risk type and strategy below.

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EXECUTIVE SUMMARY

After four generations, Joe Meier and C&D Farms are at a crossroads. With his children unwilling to take on the farm and its assets, Joe must decide which of three specialization strategies would be most beneficial to both himself as well as Tom Smith, Joe’s head supervisor and potential future owner/operator of C&D Farms.

The first strategy involves eliminating the production of alfalfa and corn silage for his dairy herd and purchasing feed instead, diverting that land to corn and soybean production. The second encompasses liquidating the dairy operation altogether, while the third—in addition to discontinuing dairy—includes renting an additional 500 acres of land to increase corn and soybean production.

While the future is still unclear, at the end of the day, Joe would like to spend more time with his family and less time working with livestock. All three options have their pros and cons, but it’s clear that risk reduction strategies will need to be put in place if Joe wants to uphold the farm’s profitability.

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C&D Farms: Thinking about Strategic Direction

Harvest is almost complete and the last cow has been milked, and Joe Meier, 55, is sitting on his porch watching the sun on the horizon. There never seems to be much time to think about the future, but lately Joe’s thoughts have been returning over and over to this very topic. Joe is proud of his farm’s performance during the last several years. However, he often wonders, particularly as of late, whether his diversified operation needs to become more specialized. Many of his neighbors and friends have dropped their livestock operation. The few that have remained in the livestock industry have greatly expanded the size of this part of their operation. Joe is wondering whether he should change strategic directions by specializing in the production of corn and soybeans. This would entail not producing forages and discontinuing the dairy operation.

Joe recently attended a workshop where the authors discussed using scenarios or alternative strategies to examine changes in an operation. Joe thinks comparing his current situation (i.e., the base case) with three specialization strategies would be a helpful way to strategically think about diversification and specialization. The three scenarios that Joe has identified to examine include the following: (1) purchase rather than raise feed for the dairy operation; (2) discontinue the dairy operation and produce corn and soybeans on all of the crop acres; and (3) discontinue the dairy operation, rent an additional 500 acres from a neighbor that is going to retire in the upcoming year, and produce corn and soybeans on all of the crop acres. Obviously, the third scenario will have relatively higher net returns than the second scenario. The second scenario is utilized to measure the direct impact of dropping the dairy herd.

Risk measures were also briefly discussed at the workshop that Joe recently attended. If risk is going to be included in the analysis, Joe realizes that it is important to use multiple years in the analysis. Thus, comparisons of the base case and the three scenarios will focus on the ten-year averages of value of farm production, net farm income, and operating profit margin ratio. Historical data is used to compute the ten-year average performance measures for the base case and the alternatives to the base case. In addition to comparing the averages, risk comparisons are conducted. Standard deviation is a commonly used measure of risk. Given two investments or strategies with the same average, a risk averse individual will prefer the strategy with the lower standard deviation. Some analysts prefer to use a measure of relative variability rather than the standard deviation, which is a measure of absolute variability. The coefficient of variation (CV) measures relative variability and is computed by dividing the standard deviation by the average. Again, given two strategies with the same average, a risk averse individual would prefer the strategy with the lower CV.

History of C&D Farms

Joe’s great grandfather, Walter, purchased 120 acres in north central Indiana in 1910. This was the beginning of C & D Farms. His vision was to build a business that would provide adequate income for his family. An added bonus was a lifestyle that was more serene and even-tempered than what he left behind in Chicago. By the time he died in 1960 at the age of 80, the farm had grown to 250 acres and his son, Paul, Joe’s grandfather, was managing the farm successfully. In 1960, the farm had 250 acres of corn, soybeans, and hay as well as 15 sows and 20 dairy cows. The question of Paul, as the oldest son, becoming a farmer was never debated. Paul managed the farm until 1980 when his only son, John, took over the reins. In 1980, the farm had 500 acres of corn, soybeans, corn silage, and hay as well as 30 dairy cows. The swine operation was discontinued in 1975 so that the farm could place more focus on the dairy operation. As with Paul, John always assumed that he would take over the management of the farm upon his father’s retirement. John received a degree from Purdue in animal science and was particularly interested in the dairy operation.

Joe joined the farm operation in 1990 after completing a degree in agricultural economics at Purdue. Joe considered employment off the farm after graduation, but felt that farming was his true passion. This decision was not as easy as the decisions to farm made by Paul and John, Joe’s grandfather and father. In particular, the relatively low returns experienced by the farm in the mid-1980s made Joe’s decision to return to the farm difficult. When Joe took over the management of the operation in 2000, the operation consisted of 750 acres of corn, soybeans, corn silage, and hay; and 150 dairy cows. The farm still has 150 dairy cows. Not increasing the dairy herd was a conscious decision by Joe. He enjoys raising crops, but does not have the same passion for livestock production as his father. Joe still uses his father John as a sounding board. However, due to recent health issues, John is only able to work part-time for the operation.

In 2012, C & D Farms planted 600 acres of corn, 600 acres of soybeans, 150 acres of corn silage, and 150 acres of alfalfa. Average yields during the last ten years were 145 bushels, 47 bushels, 3.6 tons, and 19.8 tons for corn, soybeans, alfalfa, and corn silage, respectively. Joe purchased crop insurance for his corn and soybean acres, but not for the forage acres in 2012. Crop insurance would have been available for the corn silage acres. The farm owns 500 acres and rents the rest of the ground close by, mostly from former neighbors who are now retired and living in town. Some of the ground is rented from aunts that live in Chicago and Indianapolis.

Joe raises all of the alfalfa, corn, and corn silage used by the dairy operation. In a typical year, of which 2012 was not, only about 55 percent of the corn silage and alfalfa is used by Joe’s dairy herd. The rest is sold to neighboring farms. Joe’s forage production strategy has always been to raise enough feed for his herd even in low production years. Thus, even in 2012, in which Joe’s farm experienced a serious drought, Joe sold part of his alfalfa and corn silage crops.

Joe (45 years old), with his wife Emily (44 years old), raised three daughters who are now either working in town or pursuing degrees in something other than agriculture. None of the daughters has expressed an interest in coming back to the farm. However, Joe’s full-time employee, Tom Smith (35 years old), who plays a key role in supervising the employees that milk the cows, would like to become an owner/operator of a farm in the future. As Joe becomes older, he would like to free up more time for vacations and visiting his daughters and their families.

Financial Position and Performance

As a proud agricultural economics graduate, Joe prides himself on his financial record keeping system. Overall, the farm has been quite profitable during the last ten years. Tables 1-5 present the balance sheet, income statement, sources and uses of funds statement, the statement of owner’s equity, and financial ratios for 2012. EBITA, reported in Table 5, is an abbreviation for earnings before interest, taxes, and depreciation and amortization. Appendix Tables 1-5 contain definitions as well as the relevant computations for the financial ratios presented in Table 5. All of the variables used in the financial ratio calculations are contained in Tables 1-4 except for principal and interest payments on term debt, and the opportunity cost on owned equity. Principal and interest payments on term debt were $37,667 and $29,255, respectively. The opportunity charge on owned equity ($301,190) was computed by multiplying average owned equity by a long-term interest rate (6.92 percent). This opportunity charge reflects the fact that owned equity could be invested outside the farm if it was not tied up in the farm business.

Despite having a relatively strong cash balance (cash comprises approximately 7 percent of total assets), the current ratio is below 2, a commonly used gauge. Part of the reason for this is the farm’s crop marketing strategy. Crops not fed are typically sold in the year produced and thus do not appear on the end of the year balance sheet. At 13 percent, the debt to asset ratio is relatively low. The farm purchased land in 2007 as well as several pieces of machinery during the last several years. The machinery was purchased, at least in part, as a tax management response to several profitable years in a row. As evidenced by the strong repayment ratios, the farm can readily service the debt incurred through the recent land and machinery acquisitions.

The operating profit margin and asset turnover ratios were 0.1920 and 0.2819 in 2012. Multiplying these two ratios together yields a rate of return on farm assets of 0.0541 or 5.41 percent. At first glance this may not appear to be a very strong rate of return. However, it is important to note that this rate of return does not include capital gains on land. As noted in table 4, the value of owned land increased $482,000 in 2012 alone.

Gross revenue per worker represents a measure of labor productivity. The number of workers includes operators and hired employees. In addition to Joe Meier and Tom Smith, C & D Farms has 2.85 full-time equivalent workers that help with crop and dairy enterprises. Using this information, gross revenue per worker for C & D Farms was $327,530 in 2012. In general, a value over $500,000 per worker is satisfactory. However, specialized livestock farms typically have a ratio value below $500,000.

Before discussing three scenarios related to specialization, it is important to discuss financial performance over a longer period of time. Table 6 presents the ten-year average value of farm production, net farm income, and operating profit margin ratio for the base case (i.e., current enterprise mix) and the alternatives to the base case or scenarios. The average value of farm production and net farm income was $1,116,286 and $214,785, respectively. The average operating profit margin ratio from 2003 to 2012 was 0.1724. The annual operating profit margin ratio ranged from 0.0456 in 2005 to 0.2947 in 2011.

Looking to the Future

C & D Farms would like to examine three specialization scenarios or strategies. These strategies are consistent with Joe’s views on his desire to spend more time on row-crop production and less time working with livestock, his desire to spend more time with his family, and the fact that the farm can add at least some acres with little to no increase in labor requirements and machinery. Joe has shared his thoughts with Tom Smith. Though Tom currently spends most of his time with the dairy enterprise, he does not have a strong preference with regard to crop or livestock production.

The first scenario is to purchase alfalfa and corn silage rather than raising these feedstuffs on the farm. This strategy does not increase specialization as much as the other two scenarios, but it does free up time and allow the farm to produce more corn and soybeans. Also, this strategy allows the farm to liquidate relatively expensive forage equipment.

The average value of farm production, net farm income, and operating profit ratio for the first scenario is presented in the second column of table 6. The ten-year average value of farm production is lower for scenario #1 than it was for the base case. However, the ten-year average net farm income and operating profit margin ratio (see the 03-12 lines for these items in table 6) is relatively higher for scenario #1. Moreover, the CVs for these two measures are relatively lower for scenario #1. In summary, scenario #1 shows that it would be possible to purchase alfalfa and corn silage rather than raise these crops. This is due largely to the fact that the specialized equipment used to grow these crops is relatively expensive. A decision to purchase these crops would also need to consider forage quality which was not addressed in scenario #1. It is assumed that quality forage could be purchased locally. This of course may not be the case.

The second scenario is to liquidate the dairy herd and the specialized forage equipment. Under this scenario, the farm does not add crop acres. This scenario is primarily used to determine how much income would decline without the dairy herd and the associated forage production.

The average value of farm production, net farm income, and operating profit margin ratio for the second scenario is presented in the third column of table 6. The ten-year average value of farm production and net farm income (see the 03-12 lines for these items in table 6) are considerably lower for scenario #2 than they are for the base case. Also, the operating profit margin ratio for this scenario is substantially lower. It is also worth noting that the CVs for income and the operating profit margin ratio are substantially higher for scenario #2 indicating that this scenario is relatively risky. In summary, income and profitability would decline and risk would increase if Joe was to discontinue the dairy operation.

Joe has recently been approached to rent an additional 500 acres from a neighbor that will be retiring in the upcoming year. If he does not liquidate the dairy herd, he is not particularly interested in taking on these acres. However, if he liquidates the dairy herd and the associated forage production, he would be very interested in adding these acres to his operation. Thus, the third scenario examines the liquidation of the dairy herd and the addition of the 500 acres. Under this scenario, all of the crop ground would be used to grow corn and soybeans.

The value of farm production, net farm income, and operating profit margin ratio for the third scenario is presented in the final column of table 6. This scenario looks quite a bit better than the second scenario. However, income and profitability are still lower and risk is still higher for this scenario than it is for the base case or scenario #1 which maintain the dairy herd. In particular, the operating profit margin ratio is considerably more variable under scenario #3. The operating profit margin ratio for this scenario ranged from -0.2631 in 2005 to 0.2527 in 2007.

Concluding Comments

Joe Meier has been pondering whether his farm needs to become more specialized. Currently, the farm produces corn, soybeans, alfalfa, and corn silage, and has a dairy herd. Specialization could entail purchasing rather than raising alfalfa and corn silage as well as liquidating the dairy herd and focusing on corn and soybean production. The farm has been relatively profitable over the last ten years. Analysis results indicate that it would be prudent for Joe to consider purchasing the alfalfa and corn silage needed for the dairy herd rather than raising these crops himself. However, discontinuing dairy production would have a negative impact on income and profitability, and increase risk even if Joe was to farm an additional 500 acres. It would take more than 500 acres of additional acres to replace the income lost from the dairy operation. Even if the income lost by discontinuing dairy production was replaced with increased crop production, it may not be feasible to reduce risk to the level of Joe’s current operation. This result is not that surprising given the importance of crop and livestock diversification as a risk management strategy.

Now that a brief summary of the average and relative riskiness of several alternative scenarios has been conducted, the next step would be to develop a set of pro forma financial statements for the base case and one or more of the scenarios. This could be done using spreadsheets or software such as FINPACK.

This case was developed and written by Michael Langemeier, Clinical Engagement Professor in the Department of Agricultural Economics at Purdue University, October, 2013.

Key Questions


1.

Joe’s employee, Tom Smith, helps supervise employees involved in the crop and dairy enterprises and would like to one day own and operate a farm. How could Joe bring Tom into the decision making process and should he?

2.

What are some methods to reduce risk other than diversification that Joe could use if he eliminates the dairy operation?

3.

In addition to the three scenarios Joe identified, are there any others you would suggest he consider? Why?

EXECUTIVE SUMMARY

The future of Deer Creek Farms is up for grabs. The landscape was very different 32 years ago when George and Carol first took over the family farm. Now, with their pending retirement, it’s clear their two children, David and Emily (with their spouses) have different ideas regarding which direction the farm should head.

Deer Creek Farms was homesteaded in 1867 and has been raising livestock and growing corn, wheat and oats throughout its history. Over the years, the farm was able to survive by diversifying, embracing new technology and adapting when needed. In order to continue and grow, Deer Creek Farms must take advantage of each family member’s unique talents.

The task at hand, then, is two-fold: 1) find a way to develop a new, workable farm plan that will support all three families—as well as generate enough surplus to allow David and Emily to eventually buy out their parents, and 2) find ways to successfully transfer ownership and expand the operation with careful consideration to contingency, exit and downscoping strategies—all while keeping risk at a manageable level.

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Deer Creek Farms: Tradition into the Future

George is walking through one of his hog barns on this crisp fall morning thinking back over the last 32 years. They had not all gone well, but overall, he had no complaints. Thirty-two years ago this week his father, William, had collapsed while out feeding cattle and left George to figure out where Deer Creek Farms should go in the future. It was a difficult time for the family dealing with an unexpected death and struggling to decide if Deer Creek Farms could survive such an abrupt change in leadership. George had spent his entire life working on the farm and picking up odd jobs from neighboring farms when needed. It was more than just his livelihood; it was a part of him. Both he and Carol, his wife of 35 years, were scared to take on ownership of the farm, but they were even more afraid to let go of their dream of one day operating Deer Creek Farms.

Carol had grown up in Indianapolis and had dreamed of living in the country since a little girl attending the State Fair. She loved looking at the prize winning cattle and hogs every year. Carol and George later met after Carol earned her teaching license and moved to Carroll County to teach second grade. Carol was twelve years younger than George and while the age difference never seemed to bother either of them before, George was beginning to worry about retirement and spending as much time with Carol and their children as possible. William was only five years older than George is now when he died, and George would like to transition the farm to his children while he is still capable of helping them make decisions and provide labor. Carol has always joked that George will never retire and if the children intend to come back to the farm George will be living in their basement running the farm from behind the scenes. While this joke has been taken lightheartedly, George knows the children need a chance to learn from their mistakes; after all, he certainly made enough of them.

George and Carol’s two children loved growing up on the farm. David could often be seen pulling his Little Red Wagon behind him with tools, parts, feed, anything he thought his dad might need. Emily was usually sitting in the barn talking to her animals and “diagnosing” them as she pretended to be a veterinarian. David has been working in town and helping farm on the weekends since he went to college nine years ago to be an agronomist. His wife Susan is in her first year of practice as a pediatrician and they have a child on the way. David and Susan had indicated last Thanksgiving that when they had kids they wanted to raise them on the farm as David and Emily had been raised. Looking back, George realizes they must have been hinting at their plans, but at the time, both he and Carol thought the statement was simply made in passing.

Emily will graduate from college this spring with an animal science degree. She has never let go of her love for animals, but she has decided not to pursue veterinary school, at least for now. Her fiancé, Jacob, will also graduate in May with an agribusiness degree. If George could get the kids to work together, he thinks Deer Creek Farms could continue to be successful. However, the farm would need to support three families and three generations – not an easy task.

As George makes the short walk back to the house for his morning coffee he reflects on the mission of the farm: Deer Creek Farms is more than a family farm that provides the highest quality of corn, soybeans and hogs. It is a living entity. The original homestead was settled in 1867 in Deer Creek Township. Since then, the farm has provided for the livelihood of generations of families and farmworkers. We are committed to providing every member of the family a chance to take a meaningful role in the business. In addition, we seek to be a contributing member of the farming community, and to treat our employees, suppliers, buyers, and others with whom we do business, with integrity and dignity.

The mission statement had been the idea of the local Extension educator and insurance agent as they worked with George and William to identify the farm history and plan for the farm’s 100th birthday celebration. It has always been a source of pride that the family and Deer Creek Farms have been able to survive since its founding and they have seen and adapted to many changes. From its initial start growing corn, wheat, oats and raising livestock, it has diversified and embraced technological innovations. Deer Creek Farms must continue to change and grow, while utilizing the unique talents of each family member to continue this legacy.

George’s focus over the last 32 years has been on corn, soybeans, and finishing hogs. He has some ideas for expansion in each of these areas, but he has a feeling the kids will have other ideas. David would prefer to spend more time focusing on the agronomic aspects and eliminate the feeder pig enterprise when the contract expires. Emily on the other hand has always mentioned that she doesn’t understand why there are few beef cattle in Indiana and would like to have a cow-calf herd in addition to the hogs. Jacob may end up being the outside opinion that they all need to listen to as they put his agribusiness skills to work helping them identify the best route to move forward.

Deer Creek Farm Today

Currently, George is farming 1,640 acres of corn and soybeans and finishes a minimum of 12,000 feeder pigs annually on contract. In 2011, Deer Creek Farms average corn yield was 168 bushels per acre and average soybean yield was 55 bushels per acre. Due to the drought in 2012, yields were down to 116 bushels per acre for corn and 42 bushels per acre for soybeans. George and Carol own all of the acreage. The first 800 acres were inherited after the passing of William and include the original homestead where the house and hog facilities are located. George then kept his eye on land sales in the area over the years and picked up additional acres when possible. He purchased 200 acres in 1982, 480 acres in 1990, 120 acres in 1995, and 80 acres in 2003. He has been hesitant to make any purchases recently due to high land values. The rental market in the area has also been competitive enough that they haven’t tried to increase acreage through renting.

George’s philosophy has always been that there was no need to have the newest equipment in the field. He is capable of doing many of the repairs himself and has strived to maintain the right size machinery for the farm and not buy the newest and biggest equipment just because it is available. The primary equipment on the farm is a 360 PTO horsepower tractor, 320 horsepower combine, 8-row (30” rows) corn head, 36 foot chisel plow, 39 food field cultivator, 36 row conventional planter, 100 foot boom sprayer, and 30 foot grain platform.

The contract hog production was a way for Deer Creek Farms to stay in the hog business without as much market risk. Logistically hog production is ideal because of the proximity to a local processing plant in Delphi, IN. George has always felt a connection to the industry, but he had struggled in the last 15 years to market the hogs at a profit. The current contract provides a guaranteed payment of $162,000 each year per barn as well as the opportunity for bonuses based on performance. George provides the building, labor, and utilities and the contractor provides the pigs, feed, veterinary services and medication, and transportation. George appreciates the consistent income and typically receives bonuses for low death loss and high feed efficiency.

Ideas for the Future

George and Carol are in agreement to share the news of their phased retirement with the children at Christmas and make the official transition once Emily and Jacob graduate in May. George would like the farm to continue as close to its present state as possible, but understands the need for change and evaluation of where they are going. George changed the cropping mix and William eliminated the cow herd, so each generation has made adjustments and George is prepared for the adjustments the next generation might make. Carol is fine with whatever changes are made as long as everyone supports each other through this process.

David

David is currently working as a crop consultant. He truly loves his job but hates the stress during the summer. It isn’t the hard work or the long hours that bother him, after all, he was raised on a farm; it is the stress of not being around to help on the family farm during some of the busiest times. David would like to see Deer Creek Farms expand their acreage and wants the farm to become a seed dealer. David is confident that they could rent more ground to expand their corn and soybean production, and he has already built a strong rapport with many of the area farmers as a consultant. He knows there are some risks involved with expanding the corn and soybean enterprises, but he would rather stick with what he knows than try to expand into another area. He especially would like to eliminate the feeder hogs. One time his family went to visit an aunt in California; only one time in his 27 years did they go on a family vacation, because of those darn hogs!

Susan

Susan would love to have her and David’s children raised on a farm. Her grandparents farmed when she was growing up and she enjoyed spending holidays and occasional weekends there. She has been listening to David’s stories about his childhood (and lack of vacations) for the last seven years and thinks it sounds perfect. With a baby on the way, Susan cannot think of a better time for David to be a part of the farm full time. Susan will continue to work in town and can provide consistent off-farm income as well as labor during the busiest seasons.

Emily

Emily is counting down the days to graduation and the wedding. With her and Jacob’s wedding the weekend after graduation and senior classes at college, looking for a job has seemed relatively less important to her. In her mind, now would be a perfect time to take over leadership roles at the farm. She has worked part time in the animal science department as a student worker and would really like to add a cowherd back to Deer Creek Farms. Emily knows the drought conditions the last several years have caused some producers to cull their herds. She thinks they could buy heifers now and be ready when the prices go back up. Emily is afraid the biggest challenge will be getting her brother to listen to and respect the ideas of his younger sister. However, they have always had a strong relationship and David and Jacob are quickly becoming like brothers.

Jacob

Jacob and Emily are planning to get married in the next few months. Jacob has had interviews with Farm Credit Mid-America and several area banks. He would like to be a loan officer. Jacob grew up on a farm, but his dad could never seem to get ahead and they eventually lost the farm when Jacob was in high school. This is part of what shaped Jacob’s decision to obtain a degree in Agribusiness. He wanted to be able to help farmers like his dad better understand the decisions they were making. His college advisor encouraged him to get a masters degree and work in Extension, but he is convinced he can help farmers just as much by working as a loan officer and helping them understand the implications of borrowing money along with doing a better job evaluating loan requests. Jacob knows Emily wants to be a part of Deer Creek Farms as soon as possible. He would like to be a part of the farm as well but recognizes the need to have work experience off the farm and after seeing the struggles of his own family’s farm would like to build their finances first.

Decision Making

Carol has decided the best way to keep the peace and have everyone work together on the future of Deer Creek Farms is to schedule a family dinner with a chance for each member to give a 15-minute presentation of where they would like to see Deer Creek Farms go in the future. The task is to develop a workable farm plan that can support the families and generate enough surplus to allow David and Emily to eventually buy out their parents. Carol is excited to see the kids’ presentations and hopes this will be a peaceful time for George as well. She knows he is confident now is the time to transition the farm, but she is a bit worried about his reactions to the children’s suggestions (especially if they vote to eliminate the feeder hog enterprise).

Carol’s main role in the business has been to provide labor during the summer when school was not in session and to keep the financial records. Sample enterprise budgets for 2012 (tables 1-2) as well as farm financial ratios (table 4) are included to illustrate the current position of Deer Creek Farms. Carol has worked with Emily to develop a possible cow-calf budget (table 3) for Deer Creek Farms to discuss during the planning meeting.

An important step in the decision making process is to identify the potential scenarios that might unfold under all of the proposed plans. Next, it is important to recognize that things may not go as planned. A contingency plan should be developed to identify potential disasters, emergencies and threats as well as the family member/employee in charge, and how to respond to each disaster or threat. One method Carol has suggested the family use is scenario planning to visualize the potential for the expansion plans under uncertainty. The steps of scenario planning are provided in figure 1. A contingency plan outline is included in figure 2 to be used by Deer Creek Farms. The tools will be useful in helping the family evaluate the risks of each proposed scenario. One strategy that is often overlooked but important to consider is exiting or downscoping. It is important not to view these decisions as business failure but merely a period of transition or reallocation of resources to another operation. The farm has exited out of enterprises in the past and should not be afraid to do so in the future when an activity no longer meets the business’ overall plan.

This case was developed by Elizabeth A. Yeager (Assistant Professor, Purdue University) and Sarah A. Stutzman (Graduate Research Assistant, Purdue University). Copyright 2013, Purdue University, West Lafayette, Indiana 47907. All rights reserved. The authors would like to thank the Indiana Soybean Alliance for their support of this project.

Yeager, E.A. and S.A. Stutzman. 2014. “Deer Creek Farms: Tradition into the Future.” American Journal of Agricultural Economics 96(2): 598-605 doi:10.1093/ajae/aat108. Impact factor: 1.507.

This case study has been published with the proper citations.

Key Questions


1.

Deer Creek Farm is faced with options to expand current operations or diversify. What questions do the family members need to consider as they make their decisions?

2.

How can Deer Creek Farm expand while keeping risk at a manageable level?

3.

What are ways the farm may be able to transition ownership or reduce the risks associated with increased or changing owners?

4.

Scenario planning is a common tool used to evaluate strategic risk. Follow the steps outlined in Figure 1 for one scenario. Did your opinion on the scenario change after using this tool?

5.

Contracts are key to the hog finishing operation. What are the opportunities and risks associated with this and how might they be managed?

6.

Figure 2 shows four key components of a contingency plan. Provide an example for Deer Creek Farm.

EXECUTIVE SUMMARY

It’s all about relationships at Huffman & Hawbaker Farms, a “true Indiana family farm.” Over the years, constant experimentation with new enterprises has helped keep the operation nimble and productive. But it’s the many enduring business relationships forged by General Manager Levi Huffman that has proven to be the farm’s main anchor. Driven by trust, reputation and goodwill, some of these relationships with various buyers, suppliers, landlords, lenders and employees have spanned decades, and all have played a critical role in the operation’s overall strategy and profitability. Recently, it’s become abundantly clear to Levi that times are changing, and soon, a new generation of landowners will be assuming control, bringing with them a whole new range of risks.

While continued growth for the operation will, in part, depend on how the farm continues to create and capture value—particularly in regards to their portfolio of specialty crops—it’s how they manage the risks that come with these relationships that will determine the farm’s future.

Business Risk Examples

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For Better & For Worse: Navigating the Uncertainties of Family Business Relationships


As Levi Huffman, General Manager of Huffman & Hawbaker Farms, boarded a plane headed to Lincoln, Nebraska for the annual North Central Risk Management Advisory Board Meeting, he reflected on the risks in farming. Crop prices have always been volatile, but in the past few years the markets have been like a roller-coaster. And then the drought of 2012 hit, worst drought since 1988 for his farm. But a recent conversation with a couple of friends had made him think about some other risks. One had lost the lease on 25% of the acreage he farmed to a neighbor who outbid him on the rent. The other was a contract hog producer, but the hog production company decided to restructure and consolidate their business. His production contract was not renewed. Over the years Levi had developed many long-term business relationships that span decades. Many of these relationships are with landowners that have a high degree of trust for his family. However, times are changing and a new generation of landowners will be making their own decisions. Other business relationships are changing too. Suppliers and buyers are becoming larger and his business relationships are becoming older. He began to wonder what he could do to be one step ahead of these changing relationship dynamics and the risks they pose for his family business.

Huffman & Hawbaker Farms

Huffman & Hawbaker Farms is a “true Indiana family farm.” Family has always been a core part of the success of the farm. Levi joined his father-in-law, Ralph Wise, on the farm in 1972. Over the years, his children and their families have joined the farm operation. Levi is the general manager of the farm. His son, Aaron, manages the grain crops and hog operation. His son-in-law, Jim, manages the vegetable crops. There are four other full-time employees. One works in the crop and hog part of the operation. The other three work in the vegetable enterprise.

By 1979, Levi was farming 1400-1500 acres. Now they operate 3,100 acres. They typically grow 2,650 acres of corn and soybeans and 450 acres of specialty crops each year. They own 15% of the land they operate and rent the rest. Around 60% of the acres that they rent are built on arrangements that they have had for 40 years.

The hog operation also has a long history. When Levi joined the farm, they had a 200 sow farrow-to-finish facility and added a 540 sow farrow-to-finish facility to the hog operation in 1979. The hog operation was very successful in the early years and was the fundamental contributor to much of the farm expansion during this time period. In 1994, the hog house burned down. Reflecting on this, Levi’s wife, Norma, commented “If a building was going to burn down, it is unfortunate that it was the hog facility that was making money at the time. We had been losing money on birds in the poultry facility.” They rebuilt the hog facility in 56 days and continued production but began to have problems with PRRS outbreaks and market fluctuations. In 1998, they experienced a loss of $40 per hog due to market fluctuations which led to a large loss in equity. After this experience they decided to transition to contract production and now they produce hogs on a production contract with Signature Farms.

Levi and his family are always experimenting with new enterprises and products to see if they are a good fit for the family’s resources. The timeline in Figure 2 illustrates the number of different ventures that the Huffmans have tried. In the 1980’s, they bought ground with a chicken house with 30,000 bird capacity and purchased a used building which brought capacity to 110,000 birds. In the 1990’s, the income from chicken production grew increasingly volatile. In one year they made $200,000 and lost the same amount the next year. They exited poultry production in 1995.

Specialty crops have also played an important role in the expansion of the farming operation. In 1999, they decided to transform an existing building into a packing shed for specialty crops. In 2011, they obtained USDA certification for this building. Over the years, they have tried several specialty crops including cabbage, mini-gourds, mini pumpkins, and decorative Indian corn. The purchasing offer per pound for cabbage was too volatile causing them to exit this crop in 2006. For the mini-gourds and mini-pumpkins, economic conditions at the time indicated that the demand for decorative items would soften. They exited this crop and observed Wal-Mart prices that were $0.12 per item below production costs the next year.

In addition to the hog and grain side of the business, the Huffmans also manage 450 acres of tomato and pepper production. Current contracts include arrangements with two different salsa companies as well as a contract with Red Gold. Each processor has a unique contract that the Huffmans are able to use to increase efficiency of the specialty crop venture. One salsa company has more quality specifications than the other. A premium for the higher quality production can be captured by segregating the production by quality characteristics.

From careful management of soil nutrients to thoughtful and mutually benefitting contracts with landowners and processors, the Huffmans follow their management philosophy in all aspects of the business. The mission statement of the farm is: “To be good stewards of God’s many blessings, the Huffmans endeavor to produce quality agricultural products by using their abundant resources, preserving the family farm entity while meeting the individual needs of each family unit, offering a helping hand where needed and maintaining a sense of community responsibility while being governed by Christian principles.”

In contrast to many Indiana farmers, Levi and his family have chosen to expand their business by focusing on value added crops. This focus has come from community values, respecting neighbors, and not wanting to bid land away from neighboring land owners. Levi says, “Since it is hard to acquire new acreage while still maintaining our goals and mission statement, we strive to increase our return on acres already owned or rented.”

The Risks and the Opportunities: Entering and Exiting New Ventures

Farming has a high level variability and one significant challenge is determining when the outlook for an enterprise is no longer profitable. While remembering his experience with poultry production, Levi says it is important not to “ride a dead horse too long.” The most significant experience of not expanding a venture occurred in 1997. At this time, the Huffman operation had expanded greatly due to the success of the hog operation. When they obtained a hog building permit for 1200 sow, it seemed like this would be the best way to expand the business. They discussed the option of expanding the hog operation in this way with the family and brought the concept to bankers. After discussing with bankers, it became apparent that the expansion would leverage the business too far and the debt to asset ratio would be greater than 50%. Consequently they decided not to expand since their leveraged position and risk associated with the return decreased the attractiveness of the venture. The next two years were difficult years for the hog industry. This would have put the family in a very difficult position if they had decided to expand. Reflecting on this decision, Levi said, “The Lord was looking over us. If a banker would have been more supportive of the investment, we would have gone ahead with the project and would still be experiencing the consequences of that decision today.”

Specialty crops come with their own set of entry and exit challenges. One of the largest risks is changes in market access or purchasing contracts. Red Gold provides a strong base contract for tomato production which provides flexibility to experiment with other crops. Cabbage is one crop that the family has tried. Due to volatile market fluctuations in 2003-2006, they exited this venture. However, market conditions have changed and they are considering re-entering cabbage production.

Buyer Relationships

Although the Huffmans could market their grain to Tate and Lyle or other nearby locations, they choose the Andersons as their grain purchasers. Levi uses futures and options as part of his marketing strategy. They store the grain on site and sell to Delphi or Chalmers. For soybeans, they also sell to the Andersons. For all of the marketing of the grain, the Andersons take care of the margin money. When markets are high, he typically begins pricing 2 years before he begins planting. Levi meets with the Andersons once a month and calls 3-4 times a week. “I spend more time watching commodity prices than on any other aspect of the farm,” he says.

Due to market fluctuations over the years, Levi says that the farm’s “interest in hogs has waned.” Depending on the death loss rate per group of hogs and current feed prices, the hog operation is leased on a $33-38 per hog space rate for 3 years at a time to Signature Farms. The Huffmans also receive the manure as fertilizer which is around $8 per pig space value when the building is full. Contracts with Tyson, Indiana Packers and other companies required investment toward facility ventilation. Signature Farms is able to work with the Huffmans with what they have. They are paid quarterly for the 3,050 pig spaces in the building. The Huffmans are responsible for the care of the animals which includes administering rations, medicines, and facility maintenance. Also, they get paid even if the barn is not full.

The specialty crops are the most work in terms of maintaining the business relationships. Maintaining quality standards, a consistent supply and above average food safety standards are the three largest concerns. These contracts are written to incorporate quality measures. For example, compensation for peeler tomatoes is based on percent usability that is greater than 80%, and percent of tomatoes that are type A that is greater than 60%. Compensation for tomatoes that are used for ketchup is based on color and the percent usable that is greater than 80%.

Huffman & Hawbaker food safety record programs, operation policies, and record logs provide value to their specialty crop customers and set them apart from their competition. A food safety audit form from USDA is provided in Appendix A; the Huffmans have developed a detailed 500 page protocol to manage their tomato and specialty crop enterprises to ensure compliance with USDA as well as buyer food safety and quality requirements. Although there are mock trace back trials to ensure that there are no food safety problems, trace back is still a concern that could damage their reputation and buyers’ confidence in their products. The Huffmans also create food safety plans to meet new buyers preferences. Also, with the specialty crops, the relationship dynamics with the purchaser play a much larger role than in the other enterprises. If problems arise with quality or production during the growing season, proactive communications with the purchaser can dampen any negative responses.

Over time, the specialty crop contract relationships have become more demanding. They are long-term relationships but annual contracts. Sometimes these relationships can be high maintenance, but there is transparency and open communication which reduces uncertainty. If problems arise, pictures are sent and the problem can be caught more easily. Some of the relationships require involvement in industry activities that do not necessarily contribute to farm operations. One of these relationships requires attendance from a representative of the farm at growers meetings for 3-4 days throughout the year as well as time to negotiate and monitor quality and contractual agreements.

Supplier Relationships

For their equipment supplier, the Huffmans are loyal to one brand due to familiarity with the brand. They purchase equipment and parts from Howard & Sons Inc. in Monticello. They also are loyal to one dealer based on the skills and service of the manager and staff in the parts division.

They have had a connection with their chemical supplier, CPS, since 1975. Levi says, “Service is most important and CPS will go the extra mile to help out when needed.” There is a high level of trust in this relationship. For seed, genetics is very important. It is relatively easy to switch between different brands of seed. However, suppliers are tightening contracts to obtain volume discounts and other services so that the Huffmans now have 90% of their acreage in one brand of seed that the supplier determines. Volume discounts and highly customized service keep this arrangement appealing.

Levi tends to buy all the inputs that he needs for the upcoming year around January 15th. Formal contracts with input suppliers are not common. He says “We are very loyal and stay with supplier relationships unless a problem arises.”

Landlord Relationships

Because of his reputation, Levi’s father-in-law was approached by people in the area and asked to rent their land. These relationships still exist today and are built on trust and a handshake. Levi says “[The owners] trust us and we raise the rent if it’s fair.” More recent rental arrangements have come about through bidding and winning pieces of land. These agreements are built on formal contracts where the price and terms are more explicitly stated. Their contracts are 1-year to 3-year cash rent arrangements. Lime is paid for by the Huffmans and prorated over three years if the contract is not renewed. They fix all tile breaks and also cover most of the cost of installing new tiling if these improvements are needed. In the future they believe that formal contracting will be more common. They are not too worried about losing rented acreage, but a gradual change towards formal contracting is believed to be prudent.

The rental land market is highly competitive. There are 17 landowners that lease land to the Huffmans. Of these 17 arrangements, 5 are formal contracts. Most landlords have a high level of trust with Levi and require little information about the land. The upward pressure on rents and acres transitioning to the next generation of landlords are concerns for this area of the operation. Though the contracts are becoming more formal, the Huffmans still maintain high quality operations and proof of the maintenance of the soil quality of the land that they rent. They test the soil every three years and always communicate yields.

Lender Relationships

Ten years ago, the Huffmans switched bankers. This change was primarily motivated by the previous bank’s nervousness about the specialty crop venture and the lack of expertise in understanding an organization with a large focus on specialty crops. The current lender does not require titles of the equipment and a tomato grower is on the board of the bank. The Huffmans have a very open relationship with the lender and are well within the lenders underwriting standards. They inform the bank about any problems and provide balance sheets, cash flow, income, and projected revenue.

Family/Employees Relationships

Figure 3 is the organizational chart for Huffman & Hawbaker Farms. During the busiest months of the year there are nearly 120 employees in the business. This includes ‘professional migrant’ workers. The Huffmans use this term to illustrate the value that these seasonal workers bring to the Huffman operation. They experienced labor contractors that treated the workers poorly and no longer outsource the recruiting of temporary labor. The only year that the Huffmans had difficulty obtaining enough seasonal labor was the year that Indiana was considering implementing statewide e-verify. Although they take all steps possible to validate the legality of workers, immigration checks are still a threat to operations. Over the years, they have developed a quality labor force and network. Jim Hawbaker views the specialty crop venture as a team effort. Regarding Carlos Hernandez who is in charge of training, record keeping and human resources, Jim says “He is very thorough, organized, and can handle a lot of stress and not really show it.” They do not worry a lot about losing long time employees and are working to achieve a high seasonal labor return rate.

Epilogue

As Levi boarded a plane to head back home to Lafayette, Indiana, he thought about how some of the discussions at the Advisory Board Meeting had reinforced his concerns about the strategic and relationship risks faced by Huffman & Hawbaker Farms. One of the presentations had focused on the potential for reductions in the government safety net for farmers including proposals to reduce the subsidies for crop insurance. These had been critical to their ability to withstand the financial consequences of the drought in 2012.

During dinner with another Board member who had just experienced a financial loss of $250,000 due to trading futures through the mistakes of MF Global Inc, Levi decided that they should devote their next family Board meeting to a more detailed discussion of the risks Huffman & Hawbaker Farms were facing beyond the typical production and price risks and what plans and actions they should consider to manage and mitigate those risks. One of the ideas discussed at the meeting was a risk audit. Levi and his family had experience with food safety audits, but maybe they needed to expand their focus to consider the strategic and relationship risks they were facing.

This case was developed by Benjamin Allen (Research Assistant, Purdue University) and Michael Boehlje (Distinguished Professor, Purdue University). Copyright 2013, Purdue University, West Lafayette, Indiana 47907. All rights reserved. The authors would like to thank Huffman & Hawbaker Farms for permission to develop this case around issues facing their organization. The generous contributions of information and time by Levi Huffman (General Manager), Norma Huffman (Bookkeeper), Aaron Huffman (Manager, Livestock and Grain) and Jim Hawbaker (Manager, Vegetable Crops) at Huffman & Hawbaker Farms are gratefully acknowledged.

Key Questions


1.

How should Huffman & Hawbaker Farms think about growing their business? How do they create and capture value without taking on more risks than are acceptable and manageable?

2.

Should the family incorporate more or less specialty crops into their operations? Does the portfolio of enterprises help manage the risks of the business? Do specialty crops increase the risk?

3.

Many of the buyer and supplier relationships of Huffman & Hawbaker Farms are personal with Levi and Norma. When should business relationships be linked more to the institution and less to an individual person?

4.

Contract terms and access to markets are key components to specialty crop. What are the risks and opportunities of these specialty crops? How should these risks be managed?

5.

As suppliers become larger, what should the family consider about these relationships? How can risks associated with supplier relationships be mitigated?

6.

How can the enterprise be more effective in how they approach the next generation of landowners? Are there ways that the vulnerabilities associated with changing landowners can be reduced?

EXECUTIVE SUMMARY

While there are many reasons why agricultural operators need to effectively manage risk, this case study examines why it’s critical for farm operators who rely on borrowed funds to include a lender’s perspective when developing a risk management plan. Using a coordinated approach makes sense because all interested parties have a vested interest in reducing overall risk.

By exploring topics such as land ownership, operating entities, land rental arrangements, crop insurance, marketing plans and more, this case study illustrates not only the value of incorporating the lender’s point of view, but those of attorneys, tax professionals, government agencies, marketing consultants and insurance agents as well. This balanced approach to developing a risk management plan is key to running a successful, profitable operation—particularly in today’s volatile market.

Business Risk Examples

Avoid Examples

The Perfect Storm: A Case Study Illustrating How a Series of Events Led One Farm Operator to Develop a Risk Management Plan that Includes a Lender’s Perspective

Risk management has been described as anticipating the potential for undesired events and then taking measures to either avoid those events and/or their consequences when it is cost effective to do so. Various types of risk are often grouped in production, marketing and financial categories (Wachenheim & Saxowsky, 2003). Also, greater uses of debt affects risk, because the borrower’s fixed loan payment obligations have to be satisfied through varying levels of net farm income. In fact, the importance of risk management practices increases significantly for the use versus the non- use of debt (Micheels & Barry, 2005).

This comprehensive attitude toward risk management occurs when agricultural lenders are including more profitability and repayment capacity measures in their credit analysis than the traditional liquidity (e.g., current ratio and working capital) and solvency measures (e.g., debt-to-asset ratio and debt-to-equity-ratio). Such an approach enables a more in-depth analysis as to the strengths and weaknesses of an agricultural business, as well as additional insight into an operation’s vulnerability to various risks.

The case study discussed here provides an example of a farming operation that was profitable through 2009 but experienced net farm losses, on an accrual-adjusted basis, in 2010 and 2011. The lending institution financing the operation became concerned about its financial condition and performance after preparing an accrual-adjusted income statement. The response of the lender was to require the borrower prepare a risk management plan.

The following paragraphs discuss the risk-reducing tools and alternatives proposed and reaction of the lender. The lender reaction is included to more fully understand the position and motivation of a lender when reacting to a borrower’s efforts to manage risks.

Description

The case farm is organized as a sole proprietorship. The major players are the father, who will be referred to as John Farmer, who is retired but provides seasonal, part-time labor, and the son, who will be referred to as Jim Farmer, who is the primary decision-maker. Jim has worked with his father since graduating from college about 25 years ago. During that time, Jim purchased his father’s machinery. Jim has two older sisters who are not involved in the operation and who do not wish to be involved in the future. Both sisters are married and live in other parts of the country.

John and his wife, Joan, own 615 acres, of which 610 are tillable. All their farm real estate is owned debt- free. They rent the 610 tillable acres to Jim and his wife, Janet. There is a 5-acre tract where both homesteads, machinery shed and grain facilities are located. Jim and Janet also own three semis that are used to haul their own grain and for other firms throughout the year.

Jim and Janet have two children who are in college, neither of whom has expressed interest in farming. Janet currently does not work off the farm, but she does have a Bachelor of Science degree in Agribusiness from the state Land Grant University. She worked off the farm following graduation, but has been a stay-at-home mom the past 20 years. She is currently considering entering the off-farm workforce now that both children are in college.

Production Overview

The cropping program consists of 3,879 acres of continuous corn, of which 610 acres are rented from John and Joan for $200 per acre and the remaining acres are rented from landlords located close to the owned acres. The rental agreements are negotiated annually with each of the non-family landlords. There is no livestock enterprise.

The farm is located in a very competitive area in the Midwest in terms of land rental rates. All of the 3,269 acres rented from landlords outside the family are cash rented and average cash rent paid is $250 per acre. All cash rent is paid in the spring. There are 15 non-family landlords, with two large tracts of 520 and 580 acres that rent for $300 and $275 per acre, respectively. There is fierce competition among farmers in the community to rent those two farms. The smallest parcels are two, 50- acre farms that each rent for $200 per acre and are located between the farmstead and the larger rented farms. The remaining rented acres are between those acreages and rental rates.

Through 2009, the five-year average per acre corn yield was 198 bushels, which was the actual yield for 2009. However, the operation experienced drought conditions each of the next two years resulting in actual yields of 110 and 130 bushels per acre for 2010 and 2011, respectively. The local lender has always required Jim to carry crop insurance, since the lending institution was financing the grain production and had a lien on growing crops, grain inventory, and farm machinery.

Jim carried Group Risk Income Protection (GRIP) crop insurance rather than a yield or revenue protection plan because it required less paperwork and there had been instances in the past in which the county revenue triggered a payout even though Jim did not experience a loss on his farm. That happened as recently as 2009, so Jim felt the probability of receiving a claim was higher with GRIP than with a revenue or yield protection policy.

However, in both 2010 and 2011 the reverse happened and Jim’s farm experienced reduced yields due to drought, while the county revenue was not low enough to trigger the county revenue payout. Consequently, Jim did not collect an insurance payout in 2010 and 2011. Now, Jim’s lender is becoming reluctant to approve the operating loan and agree to use GRIP insurance after the experiences of the past two years. Hence, Jim’s lender is urging him to consider a yield or revenue protection plan for 2012.

Marketing Practices

Jim does not have a marketing plan that guides his decisions when he markets grain. Instead, he watches the market and sells grain to the local elevator when he thinks there is a “good” price. Jim does not have detailed farm records that enable him to know his cost per acre or cost per bushel with a high degree of accuracy. Instead, he keeps the records he needs to file his taxes.

He has been reluctant to seek the advice of a marketing consultant to prepare a marketing plan, because he feels he can do as well as a consultant and does not want to pay the consultation fee. The average corn prices received by Jim for 2009, 2010, and 2011 were $3.50, $5.15, and $5.75, respectively; whereas average annual prices received by all farmers during those three years were $3.55, $5.18, and $6.20 (Crop Value 2011 Summary, 2012). As can be seen from the comparison, prices Jim received have been below the average received by all farmers each of the previous three years.

Financial Situation

Although John and Joan have assumed Jim and Janet will continue the family farm when they pass away, there has not been an agreement, or even a discussion, with Jim and Janet and with Jim’s two older sisters as to the equitable disposition of the farm real estate when they pass away. Jim and Janet purchased the machinery a few years ago and rent the land. They borrow the operating funds and borrow any money to upgrade machinery.

John and Joan were asked to co-sign the operating note when Jim started farming but have not been asked to co-sign notes for Jim and Janet or guarantee the operating and machinery loans for more than 10 years. The decision to not require John and Joan to co-sign the notes was made because Jim and Janet were profitable prior to 2010 and generally had a conservative attitude about borrowing money. Also, the lender knew that John and Joan were available to add financial strength to the loan.

Since there has been no discussion on how the farm real estate will be transferred, there is uncertainty as to how each sibling will receive his/her inheritance. This uncertainty has created concern, and even reluctance, on the part of the lender when Jim recently requested an increase in his machinery loan to purchase larger machinery. The lender would like assurance the home farm will continue to be farmed by Jim after the passing of John and Joan to justify financing larger machinery.

Credit Situation

To maximize the use of section 179 expensing to reduce taxable income and to prepare for the possibility of increasing the size of the operation, Jim recently traded several items of machinery. Much of the money was borrowed from the local lender and principal and interest payments were scheduled over five years. The five-year average historical yields and prices were used to justify the capital purchases and subsequent increases in the machinery loan.

Jim has historically provided a balance sheet prepared around the end of each calendar year, with assets valued at market value. The tax year for the operation is a calendar year and the Schedule F of the Form 1040, prepared on a cash basis, was used as a proxy for an income statement. To address the issue of shifting farm income and expenses between years to reduce taxable income and to minimize the resulting inaccuracies in measuring net farm income on a cash basis, the financial institution has averaged the previous three years of net farm income reported on the tax return for previous loan renewals.

Jim has historically provided a balance sheet prepared around the end of each calendar year, with assets valued at market value. The tax year for the operation is a calendar year and the Schedule F of the Form 1040, prepared on a cash basis, was used as a proxy for an income statement. To address the issue of shifting farm income and expenses between years to reduce taxable income and to minimize the resulting inaccuracies in measuring net farm income on a cash basis, the financial institution has averaged the previous three years of net farm income reported on the tax return for previous loan renewals.

However, the lending institution adopted a new loan 42 analysis software program in 2011 that prepared an accrual-adjusted income statement. The lending institution took information reported for the past two years and prepared accrual-adjusted income statements for 2010 and 2011. They were not able to prepare an accrual-adjusted income statement for 2009.

Net farm income on a cash and accrual-adjusted basis is presented below for 2010 and 2011, as well as the debt-to-asset ratio and current ratio using market values to value the assets. The term debt and capital lease coverage ratio1 was calculated by the software for 2010 and 2011 using accrual- adjusted net farm income and was used to evaluate the repayment capacity for Jim. The lender’s desired levels for the debt-to-asset ratio, current ratio, and coverage ratio are 0.4, 2.0, and 1.5 percent, respectively. As can be seen from the numbers reported, the financial condition deteriorated in 2010 and 2011.

Chart


Lender Assessment and Response

The local lender has provided the operating loan every year since Jim joined the operation and made the loans for machinery purchases. All loans have performed as agreed. The lender holds a first lien on the grain inventory, all growing crops, and all machinery. The local lending institution has always felt comfortable financing the operation, until the accrual-adjusted income statements revealed the magnitude of the operating losses for 2010 and 2011. In addition, the local lender is concerned the accrual-adjusted net farm losses occurred at a time when Jim borrowed additional money to purchase machinery, which increased his principal payments on the machinery loan.

In response, the lender wants Jim to provide a risk management plan for the operation before he approves the operating loan for 2012. The lender offered several suggestions to get the process started but would like Jim to develop his own plan so he has ownership in it, which will facilitate its implementation.

Risk Management Plan

A farming operation is exposed to numerous risks that are not only associated with the farm business, but also the well-being of the farm operator and family (e.g., health, death, disability, fire, etc.). Those risks are usually addressed through the purchase of insurance and that assumption is made in this situation. The risk management plan requested by the lender is confined to the business risks that effect the farming operation and will influence the decision by the lender to make or deny the loan request.

In general, farmers tend to combine various risk management practices to formulate comprehensive strategies when responding to risk (Micheels & Barry, 2005). That approach was used by Jim Farmer when responding to the request from his lender to formulate a risk management plan. The following is the nine-point risk management plan Jim prepared for his lender. The tools and practices proposed and the rationale for each are presented below. In addition, a section is included that presents the lender’s reaction to the tool or practice and additional requirements that might be required by the lender to approve the loan.

1. Form of Business Organization and Land Ownership

The form of business organization used in the operation is a sole proprietorship. Unfortunately, a sole proprietorship does not provide an efficient manner to transfer ownership of the land to Jim’s two sisters, except to sell those acres. An additional concern associated with the business organization is the owner’s personal assets are subject to any business liabilities. Conversations need to be had among John and Joan and their children regarding fair and equitable transfer of the real estate. Other forms of business organization should be considered after meeting with tax and estate planning professionals to evaluate the ability of each to address such issues as limited liability, intergenerational transfer of assets, the equitable distribution of farm assets to siblings not involved in a farming operation, and the flexibility to exercise tax management strategies. Possible alternatives include a sub-chapter S corporation, a limited liability company, a land trust with buy-sell provisions, as well as others (Curtis, 2006).

Other options could include: Jim purchasing life insurance policies on his parents and using the settlement to purchase his sisters’ interest in the farm in the future; after discussions among the family members about the future of the farm, Jim and his parents could set-up a lease with the option to purchase agreement where Jim would put a down payment on the farm and have the first option to purchase the land at a reasonable price; or, Jim could identify an investor who would purchase the farm ground and rent it to him on reasonable terms.

Lender’s Reaction. The lender has been asked in the past to finance machinery purchases that included larger pieces of machinery, which implies Jim will continue to farm the 610 acres owned by John and Joan. In order to be assured the operation maintains the scale needed to generate net farm income sufficient to make those principal payments, the lender would want assurance the 610 owned tillable acres owned by John and Joan will continue to be farmed by Jim in the future.

2. Operating Entities

The three semis owned by Jim and Janet are operated as part of the farming operation, which is organized as a sole proprietorship. However, the risk inherent in operating a trucking enterprise and the potential liability associated with such an enterprise suggest creation of a separate entity for the trucking enterprise. Jim and John are the primary drivers of the semis, but they do employ other employees who drive the semis. Jim plans to discuss the formation of a separate corporation for the trucking enterprise to reduce the potential liability that could arise from an accident (Legal Business Organizations, 2012). Jim plans to work with his attorney to determine whether a sub-chapter S corporation or a regular corporation would better meet the needs of the operation.

Lender’s Reaction. Again, the lender would encourage such a move. Assets owned by the corporation would be the semis and liabilities would be the debts against those semis. Consequently, the corporation, with limited liability, would have limited equity at risk should a lawsuit occur. The lender would require Jim and Janet to guarantee the loan to the corporation to finance the semis. Also, the lender may suggest evaluating the profitability of the three semis first, and if they are not profitable, it may be suggested to sell the semis instead of forming a corporation.

The lender may suggest Jim consider a corporate form of business organization as an operating entity for the farming operation as a whole for the same reason as the trucking firm, liability. This would require the loan documents comply with the regulations pertaining to loans made to a corporation, but the segregation of business and personal as well as the ability to monitor salaries paid versus a withdrawal for family living may outweigh the cost of increasing loan documentation and complexity. Again, the lender would require Jim and Janet guarantee the loan.

3. Loan Structure

Jim’s operating loan increased in 2010 and 2011, due to losses from the operation, which prevented Jim from completely repaying the 2010 operating loan. Those losses will be carried forward in the operating loan balance in succeeding years and make it difficult to completely repay those loans from the earnings for the next year. That was the case in 2011 when an additional loss was realized. Hence, the operating loan for 2012 would include operating losses for 2010 and 2011 and would be expected to be repaid from the earnings in 2012. Jim plans to ask the lender to restructure the loan.

Lender’s Reaction. The lender may suggest the operating loan for the 2011 crop, which is in inventory, be made as a separate crop inventory loan and make a separate operating loan for the 2012 crop. The segregation of the loan amounts would facilitate the determination of the amount of a loss carryover from the 2011 crop. The lender may also suggest the 2011 crop be sold, applied to loans, and purchased on paper to cover any upside market potential (with the assistance of a marketing plan). Any loss carryover for 2011 would need to be repaid over the next three to five years with annual payments and not rolled into the operating loan for the current year’s crop. Otherwise, the comingling of the loans for the two crops makes it difficult to monitor progress on repayment of the operating loan for 2012 from the proceeds of the 2012 crop.

The lender may determine if Jim would have had a negative accrual adjusted net farm income in 2010 and 2011 had he purchased revenue insurance. Using revenue assurance crop insurance at an 80 percent coverage level, Jim’s potential claims in 2010 or 2011 could have prevented or limited his negative net farm income. In the future, the lender may require revenue insurance.

4. Land Rental Arrangements

The possibility of changing from a cash rental agreement to a rental arrangement that reduces the risk for Jim should be discussed with his landlords. There is often aversion on the part of landlords to change from a cash to a share rental arrangement, especially in a highly competitive area because of the desire of many landlords to receive a cash return up front with minimum risk.

However, other alternatives are being used and one possible alternative would be a flexible cash rent lease that could be used to pay minimum cash rent close to the current market level and then share gross revenue above a specified amount based on revenue or yield. A 2009 survey of producers attending the 2009 Top Farmer Crop Workshop (TFCW) held at Purdue University found 32 percent used flexible leasing arrangements on a portion of their rented acres. Almost 43 percent of the leases were renegotiated each year, with 36 percent reporting an increase in their landlord’s willingness to make capital improvements to their farm real estate, such as improved drainage (Alexander & Patrick, 2010).

Lender’s Reaction. The lender would want to maintain the scale of the operation while reducing the amount paid in the spring and the overall risk associated with using cash rent. In Jim’s case, negotiation with his landlords would include the amount of the cash rent, base gross revenue calculation and percentage allocation of the amount shared above a specified amount of gross revenue. The fixed cash rent portion could continue to be paid in the spring if landlords insisted, while the bonus could be paid after harvest. The lender may also want assurance Jim will continue to rent the most productive acres he is currently farming, at a reasonable rate. The use of longer-term rental agreements can reduce the risk he will lose current rental acres in the next three to five years and provide incentive to both Jim and the landowners to invest in long-term improvements to the land and maintain the soil fertility (Edwards, 2011).

5. Crop Insurance

A survey of producers on factors that influence crop insurance purchase decisions found that price was the most important factor when considering crop insurance purchases, followed by compatibility with grain marketing plans and probability of receiving a claim. The two lower ranked reasons were agent recommendations and lender requirements (Ginder, Spaulding, Winter, and Tudor, 2010). However, the objective for purchasing crop insurance is to protect the producer from the adverse effects of lower levels of crop production and not as an investment from which to receive a return.

Jim is no longer in a position to ignore the importance of purchasing crop insurance from a risk management position and needs to reconsider what he has perceived as the advantages for GRIP. The increased paperwork associated with yield or revenue protection insurance is worth the protection when the county revenue does not trigger a payout. Jim is willing to reevaluate his crop insurance to reduce his production risk and work with his lender.

Lender’s Reaction. Although the probability of receiving a claim was the determining factor for Jim from 2009-2011, his financial condition deteriorated over the past two years and the need to reduce production risk for his farm is now more important than the probability of receiving a claim.

The type and level of coverage for Jim’s crop insurance needs to be reevaluated by Jim, the crop insurance agent, a marketing consultant, and the lender. They would want to compare Jim’s past experience with GRIP to what it would have been using a revenue protection plan. Additionally, claim checks for both revenue protection and yield protection can be issued within a few weeks after records are provided for the claim. GRIP/GRP claims are usually not known until February or March with the check coming after those dates. This provides a timing issue when trying to obtain next year’s operating loan. Once the decision has been made on which insurance to purchase, the lender will require an assignment on the indemnity payments in their name.

In addition, the marketing plan should be coordinated with the crop insurance product. The marketing plan could be set up to not exceed the maximum yield guarantee of the insurance product allowing Jim and his marketing consultant to be aggressive at pre-harvest pricing if needed. A 2001 study evaluated risk management strategies combining crop insurance products and marketing alternatives. The combination of a crop insurance revenue product and hedging resulted in the highest average returns among nine alternatives evaluated (Hart & Babcock, 2001).

6. Accrual-adjusted Income Statement and Financial Analysis

A comprehensive financial analysis of a farm or ranch operation must include not only balance sheet information, but also income statement information. Also, the use of a farm accounting program that prepares an accrual-adjusted income statement yields a more accurate measure of net farm income than the cash basis tax return. The annual differences between net farm income calculated on a cash basis and net farm income calculated on an accrual-adjusted basis for the 2002 through 2006 period was found to exceed 50 percent every year during the period. Furthermore, for operations with debt- to-asset ratios above 40 percent, the difference was over 60 percent (Barnard, Ellinger, and Wilson, 2010).

Farm financial analysis programs are available to prepare an accrual-adjusted income statement and various financial measures. For example, software available from Purdue University at no charge produces an accrual-adjusted income statement, the financial measures recommended by the Farm Financial Standards Council, and sensitivity analysis. Data needed for the program includes two balance sheets prepared as of the beginning and end of the tax reporting period and the cash basis Schedule F of the Federal income tax return (Wilson, Barnard, and Boehlje, 2007).

Lender’s Reaction. For an operation that has a debt-to-asset ratio above 40 percent and has experienced declining profitability, preparation of an accrual-adjusted income statement would be essential from the lender’s standpoint. Efforts to increase net cash farm income by liquidating inventory and/or increasing accounts payable and accrued expenses are revealed in a straightforward manner when using such a program. The use of a financial analysis program not only provides a more accurate measure of profitability, it also enables Jim to monitor financial performance using the same measures used by his lender. If available in Jim’s area, it may be suggested he utilize a farm management service that would ensure the records were being kept accurately and on a timely basis.

In addition, software that enables the user to evaluate management alternatives would be desirable so the projected impact on profitability and repayment capacity could be analyzed. One alternative that should be considered is the impact of Janet returning to off-farm employment, which she is currently considering. The added income could partially or totally offset withdrawals for family living from the operation during a time when principal payments on term debt have increased and operating losses have occurred.

7. Loan Guarantees

In order to improve the solvency and collateral position of the operation, Jim needs someone or some program to guarantee the operating and machinery loans. The increase in debt-to- asset ratio from 48 to 76 percent would be a disturbing development for Jim and his lender. However, the operation has been profitable up until 2010, so the situation would appear to be temporary and not due to systemic management problems. Two possibilities are to use a loan guarantee program through the Farm Service Agency (FSA) and to ask John and Joan to either co-sign or guarantee the loans.

Jim would prefer not to ask John and Joan to co-sign or guarantee the loans even though they have previously done so. The current lack of communication between family members as to the future of the farm may be viewed more negatively by Jim’s sisters if Jim defaults on the loans and John and Joan were the guarantors.

Lender’s Reaction. Applying for an FSA operating loan guarantee could be considered a first step for Jim and his lender, with a loan guarantee by John and Joan kept in reserve as a back-up plan. If Jim qualifies and receives approval for a FSA loan guarantee, the default risk to the lender would be reduced and allow more latitude on negotiating loan covenants. An FSA 90 percent loan guarantee may be possible on both the operating loan for 2012 and restructured loan from 2011. The lender may also choose to sell the loan on the secondary market. If the FSA loan guarantee is not approved, then several options could be pursued. First, the lender may limit operating funds to revenue assurance crop insurance guarantee limits. Next, the lender could ask that John and Joan guarantee the loans or co-sign the loans with Jim and Janet. Finally, John and Joan could be asked to consider a hypothecation agreement. A hypothecation is a special arrangement where John and Joan would put up specific collateral to secure the debt of Jim and Janet. If the debt is not paid the lender may have the property seized to satisfy the debt, but John and Joan are not personally liable if the collateral does not pay off the debt.

8. Limit Capital Purchases

In the past, Jim has traded machinery when he desired and then applied for a loan. However, repayment capacity of the operation deteriorated during the past two years and such a practice would no longer be acceptable. Since principal payments on machinery debt are made from net farm income, which was negative in both 2010 and 2011, principal payments on the machinery loan were likely made from the depreciation allowance, liquidating inventory or possibly included in the operating loan.

Consequently, the purchase of additional machinery using borrowed funds should be avoided until the financial condition and repayment capacity for the operation improves (Barnard & Boehlje, 1990-99). Ideally, that decision should be made voluntarily by Jim.

Lender’s Reaction. However, given that Jim has purchased machinery in the past and then arranged financing after the transaction, his lender may require Jim to provide assurance that practice will not be used in the future. The lender would also be aware that Jim could purchase machinery from a dealer and then arrange the financing of that purchase through either the dealer or by another lender, without notifying his local lender until after the transaction. In order to prevent that practice in the future, a loan requirement or covenant would likely be required by the local lender to notify the lending institution of any purchase of machinery above a specified amount. The lender may also require Jim to work with his tax preparer before any unnecessary capital investments or replacements are made. In the past, Jim was able to justify some machinery purchases with the objective of reducing taxable income; however, there is now increased concern about Jim’s repayment capacity. Future decisions should be made with the objective of maximizing after tax profits over time rather than minimizing taxes in the short term (Klinefelter, 1989). Again, this decision should be recognized and made voluntarily by Jim.

9. Marketing Plan and Tools

Increased output price volatility has caused some grain elevators in the past to reduce forward pricing contracts because they simply could not secure the line of credit to meet margin calls associated with hedging in the futures/options markets (Thiesse, 2008). In 2008, 85 percent of those surveyed at the Purdue TFCW reported their grain elevators reduced the offering of price contracts in the summer of 2008. For producers who experienced such a reduction, almost 31 percent turned to the futures market to forward price by hedging with futures and options through a broker (Alexander & Patrick, 2010).

Although the additional cost associated with hedging may be viewed negatively by Jim, the need to manage the risk faced by the operation makes it a necessity. In addition, Jim’s knowledge and experience are limited in marketing, so he may need to seek and pay for outside advice. Hence, acquiring the advice of an outside marketing consultant would need to be included in a risk management plan. Also, the marketing plan would need to be coordinated with his crop insurance product.

Lender’s Reaction. Increased price volatility in the grain markets, the risk of local grain elevators reducing the availability of forward pricing contracts, and deterioration in Jim’s financial condition makes it essential Jim develop a marketing plan and plan for marketing contingencies. Development and implementation of a marketing plan would add discipline and reduce market risk through the use of futures and/or options.

The lender and Jim should work together to determine a 2012 cash flow plan and estimate break-even points for corn. Cash flow income can be based on state FSA grain prices unless the grain is sold, then use market prices received. The FSA prices may be conservative, so Jim might have to sell a portion on cash basis or use options to set a minimum price higher than FSA to help cash flow.

The lender would likely want an agreement among Jim, the broker, and him or herself that specifies the marketing plan is to be used for hedging purposes only and not for speculative purposes. They may want to focus on cash sales and options with no storage costs. That agreement would require periodic summary reports from the broker on market positions to agree to fund margin calls and the lender should share the farmer’s break-even points and goals. The goal should be to sell or have all grain covered over the break-even point, thus, locking in a profit. The lender would want to set up a separate loan to fund the margin calls to monitor advances on that loan as opposed to including those advances in the operating loan.

The lender may also require Jim to develop a strategy for purchasing inputs. The price of seed, fertilizer, fuel and chemicals has increased in recent years with dramatic price swings in the fertilizer and fuel markets. A plan for purchasing inputs and knowing the cost of production is one step toward developing an effective marketing program.

Final Comment

The case study discussed here provides an example that risks are always present, even during profitable periods in agriculture and a risk management plan is needed to mitigate the adverse effects of those risks. The plan discussed here is not intended to provide a solution that can be generalized to satisfy the situations faced by all producers. Instead, the tools and practices discussed are suggested courses of action to provide a starting point for development of a risk management plan for this particular operation. Risks vary across operations and the respective risk management plans need to be tailored to fit the needs of each situation.

The tools and practices discussed include not only those desired by the producer, but also those that might be suggested by a lender who provides borrowed funds for the operation. Such a coordinated approach is needed, since all interested parties have a vested interest in reducing the overall risk of the operation and the input of all parties should be included as the risk management plan is developed.

The risk management plan addressed nine areas and provided tools and practices that could be used to reduce the risk in each. Although it is acknowledged other business and personal risks are often present and need to be addressed, this discussion centered on the business risks associated with financing this particular operation at this point in time.

The suggestions presented in this discussion are intended to initiate thought and discussion. Producers and lenders need to work together to develop a risk management plan, as well as seek the advice and counsel of other professionals, such as attorneys, tax professionals, government agencies, marketing consultants, and insurance agents to prepare a risk management plan. This case study was presented to illustrate such an approach.

Endnote

1 Term Debt and Capital Lease Coverage Ratio = (Net Farm Income From Operations +/- Total Miscellaneous Revenues/Expenses + Total Non-farm Income + Depreciation/Amortization Expense + Interest on Term Debt – Total Income Tax Expense – Owner Withdrawals (Total)) Divided by (Principal and Interest on Term Debt + Current Portion of Capital Leases + Prior Period Loss Carryover + Annual payments on Personal Liabilities)


This case was developed by Elizabeth A. Yeager (Assistant Professor, Purdue University) and Freddie L. Barnard (Professor, Purdue University). The authors wish to acknowledge reviews and helpful comments from Greg Foulke, Chief, Farm Loan Program, Farm Service Agency, Indianapolis, IN; Larry Kummer, President, Ag One Agency, Inc., Howe, IN; and Richard Ritter, Senior Vice President of Agricultural Lending, Flanagan State Bank, Le Roy, IL.

Barnard, F.L. and E.A. Yeager. 2013. “The Perfect Storm: A Case Study Illustrating How a Series of Events Led One Farm Operator to Develop a Risk Management Plan that Includes a Lender’s Perspective.” Journal of the American Society of Farm Mangers and Rural Appraisers 76: 19-38.

This case study has been published with the proper citations.