Young men and women and their parents attending a financial and management seminar targeting young pork producers at the Minnesota Pork Congress this year were treated to an animated presentation by David Kohl, who offered 10 guidelines for their everyday financial planning.
1. Know the Score
At the outset, the Virginia Tech professor emeritus of agricultural and applied economics zeroed in on the practical matter of credit scores. “Young producers need to check their credit scores because it is a baseline that creditors, insurance companies and potential employers regularly use to evaluate risk,” he says.
“Even as a student, you need to begin building your credit history,” Kohl emphasizes. “You need to know your score, because you don’t have a lot of net worth and you don’t have a lot of experience. Creditors and employers examine your character through your credit score.”
Recent research has shown 42% of employers check credit scores. “The lower the credit score, the higher your risk for insurance purposes and the less reliable you will be as an employee,” he explains.
The “magic number” is 700. To a lender, a 700 credit score means there is about a 5% chance of loan delinquency. But, when a credit score falls to 650, the delinquency rate rises quickly to 33%; a score of 600 has delinquency rates averaging more than 50%.
Young, married pork producers should also check a spouse’s credit score. “Since the financial crisis, more lenders will use the lowest score; some will use an average score,” he says.
Check your credit scores at least once a year; 27% of people find false information on their credit scores.
Kohl dispels the belief that checking your credit score will actually lower it. However, if there are a lot of inquiries into your credit score, it may reflect frequent applications for credit or concerned creditors frequently checking your score, which can lower it, he notes.
2. Credit Card Debt
“Be careful about credit card debt,” Kohl urges. “If you want to build your credit score, keep credit card debt about 15% under the limit and make sure you make your monthly payments. If you get too close to the limit, it will ding your credit score.”
Many lenders also check the number of credit cards a person has. No more than three is ideal, he says.
3. Student Loan Debt
Student loan debts are rapidly replacing credit card debt as a major concern. “Credit card debt is averaging $10,000 to $15,000 per family, but student debt is averaging $22,000 for undergraduates and $100,000-plus for those with professional school degrees,” he notes.
Students are asking whether the investment is worth it. The university professor says not everybody needs a university degree. “That’s why I really like community colleges and vocational/technical schools,” he says.
There is a trend toward lifelong learning, adult education and learning specific skills. “There is nothing wrong with a broader education, but I think you will see university programs shifting to lifelong learning programs, and they are going to shift pretty fast,” he predicts.
4. Balance Sheets
Young pork producers need to assess their assets and liabilities to establish their net worth early in the year, Kohl stresses.
Focus on percent equity because it is a good reflection of “earned equity,” he says. For example: If you have $1 million worth of assets and $600,000 in liabilities — typical for a young farmer — your net worth is $400,000.
“The first thing a lender will ask is, ‘Where did the net worth come from?’ With land values jumping $2,000, $3,000 or $4,000/acre over a 2-3 year period, did net worth come from appreciated land values or did earned profits actually accumulate on your balance sheet? Was it ‘earned’ net worth?” he explains.
With $400,000 in net worth and $1 million in assets, your percent equity is 40%. “This would be an understandable figure for a young producer,” Kohl says. “Pork producers tend to carry much more debt because they turn their assets faster than beef or crop producers generally do.
“When percent equity falls below 50%, you have got to be a superior manager. You have got to have a risk management program. And you have got to be modest with your family living costs,” he adds.
5. Family Living Budgets
More and more lenders want a family living budget.“You have to decide how much you are going to take out of the business to live on, and how much you will plow back into the business to grow,” Kohl continues.
“Do a monthly budget, then add 25%, and have 4-6 months of cash reserves. The average American has 13 days in cash reserves; basically, they are living paycheck to paycheck,” he notes. “If your goal is to start, nurture and grow your business, your family living cost might be $45,000 to $50,000. The average farm family living cost is approximately $85,000 for 3.3 persons.”
A common mistake of young producers is relying on the farm checkbook to evaluate living costs. “I tell every young producer: Set up a separate budget for living expenses and keep your farm expenses separate, so you know what is truly going on in your business. Lenders do not like to see personal and business expenses commingled,” he explains.
6. Working Capital
Kohl describes working capital as “the big one” for young pork producers. Do not confuse this with cash on hand. Working capital is the current assets on hand that can be turned into cash without disrupting normal operations, he says.
“This can include current inventory, accounts receivable, outstanding contracts, prepaid expenses and, of course, actual cash,” he says. “Current liabilities are your accounts payable, your lines of credit, principal reduction in the next 12 months and your accrued expenses. Subtracting current liabilities from current assets is your working capital.”
For example, for a business that generates $500,000 in revenue and has $200,000 in current assets and $100,000 in current liabilities, the working capital-to-revenue ratio is 20%.
Is that good? Kohl says the top 20% of farms have a working capital-to-revenue ratio above 40%, while the bottom 20% typically have 11% or less.
Using a James Bond analogy, he says the first thing James Bond does when he enters a room is to look for an alternative exit or backup plan. “Working capital is your resilience, your exit plan; it’s your James Bond,” he notes.
Agricultural lenders stress working capital for young producers. If working capital is hogs, corn or soybeans, your lender may ask when those assets can be sold. But a forced sale of assets could mean those assets will be sold at a discount.
Working capital can work in your favor, too. “What if the neighbor’s land suddenly comes up for sale or you are offered cash discounts on feed or fertilizer? That’s the benefit of having strong liquidity. Remember, success in financial management is not doing one thing 1,000% better; it’s doing 1,000 things 1% better. It’s those things that can put you ahead in the game,” he explains.
7. Watch Interest Expense
Be sure to include interest paid on all of your credit. “It should not be above 15% of your revenue, especially with interest rates as low as they are. I like to see it less than 10%. Make sure you calculate it over a 3-5 year period. The trend analysis is important, because one year could give you a misread,” he cautions.
8. Accrual Adjusted Income
“Never manage your business off of tax records,” Kohl warns. Take your beginning and end-of-period balance sheets and adjust for inventories, payables, receivables, etc. “If you don’t know the difference, have your lender explain them, and have them create an accrual adjusted income statement,” he says.
“Do you know the difference between what you report to Uncle Sam and what you really did in your business?” he asks. Based on studies conducted over a five-year period at Purdue University and the University of Illinois, Kohl says the difference is about 60%. “Some producers are making five-, 10-, 15-, or 20-year decisions with information that is 60% inaccurate,” he notes.
9. Enterprise Analysis
A quick read of your income statement — income minus expenses, depreciation and interest equals revenue. Farms with no debt pay no interest, but they depreciate their assets.
That can be a problem in the long run. He cites a farmer who maximized depreciation and did whatever he could to avoid paying taxes. “Faced with the sale of his business, everything was depreciated out, his assets were being sold and he had a huge tax problem — the equity coming out would barely cover his debt,” Kohl notes.
Another example — a very young pork producer generating $500,000 in revenue, after subtracting depreciation and interest, is left with $300,000 in expenses, so it takes him 60 cents to produce $1.00 of income ($300,000 divided by $500,000).
Kohl finds most efficient businesses are under 70¢/$1.00. “That’s the proverbial green light,” he explains. “The yellow light is 70¢-85¢/$1.00; when you get above 85¢/$1.00, there’s no margin to pay debt. You’ve either got to live frugally or have a non-farm income.
“That’s why you need enterprise analysis. It is critical to know what is making money in the business so you can allocate time and capital toward it. Remember, profitability turned to cash flow pays loans,” he adds.
10. Salaries and Labor
The swine industry still has a lot of farm businesses that include multiple family members. “One thing that will cause family arguments when young and old generations are involved is cash salary,” Kohl says. “Remember to place value on the perks that you get — home, fuel, locker pork, etc. This is very critical when you examine cash flow.”
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