SW Financial Literacy
3 Ways to Know if You’re Overpaying (for Ground)
I received this great question from a subscriber recently and know there are plenty of others asking the same question.
"What are the top three most important factors to consider when determining if you are paying too much for a piece of land?"
Here was my response:
#1. Cash Flow- Obviously you want the farm to be able to cash flow itself, but that isn't always possible. If you are renting additional ground on favorable terms this can help you supplement payments for the new purchase. Same goes for an off-farm income. Just make sure you weren't needing the income from other profitable farms to cover other expenses on the operation (think equipment, living expenses, etc.)
Another way to make the cash flow positive is to borrow less. By putting more cash into the purchase, you improve the cash flow and lower your risk with smaller debt levels. Just make sure you don't use up too much cash because...
#2. Working Capital- This is your short-term risk bearing ability. If you must use up all your cash just to make the purchase Cash Flow, you are paying too much. You need a strong buffer with your cash position. I advise always keeping $400 of Working Capital per farmable acre (or head of livestock) on your balance sheet. If you dip below that figure ($400WC/a), start troubleshooting your operation to find ways to create more cash.
Working Capital isn't just a buffer for land purchases. This is needed for unexpected repairs, bad yields, medical expenses, and poor commodity prices. In the past 2 year, it wasn't uncommon for a row crop farmer in the Midwest to lose between $200-500 Working Capital/acre. If they started 2023 with $700 WC/a (very strong) and had those losses, they could be at $200 WC/a right now and in a tight financial position. Protect your cash.
#3. Owner's Equity (OE)- Your equity to asset ratio can be found by taking Total Equity (Net Worth) divided by your Total Assets. So, an individual with $1,500,000 of assets and $500,000 of debt would have a Net Worth of $1,000,000 and an OE of 66.6% ($1,000,000/$1,500,000=.666). For a new farmer (<10 years), after the purchase you don't want your OE to be <25% as that is typically the point where leverage becomes too high and the operation is unstable financially. This would be similar to having $50k of credit card debt and only being able to make the monthly payments. You can survive this way, but it is dangerous and expensive.
For a more established operation (>15 years), you don't want a purchase to put your OE <50%. At this point you (should) have a much higher Net Worth, and dropping <50% is a lot of debt to take on and pay off. As your Net Worth grows, it is harder to move your OE (adding $500,000 of debt to a balance sheet with assets of $1,000,000 is a big deal, but not so much for a balance sheet with $8,000,000 of assets).
#4. (Bonus) Goals- What are you trying to achieve in your operation? Do you have plans to expand elsewhere? Were you going to start an agribusiness and need to keep leverage off your balance to allow for that? Just because you check the first 3 boxes, still doesn't mean you are making the right purchase for your farm. Have 1-, 3-, 5-, and 10-year goals for your operation and stick to it. One bad (overpaying) purchase can set you back a decade or longer, so have clarity on the direction of your operation first.
Conclusion:
#1. Have a positive operational cash flow with enough margin for error. DCR > 1.20:1.
For more on this: How to Get Financed Part 2: Capacity
#2. Working Capital > $400/a.
For more on this: How to Get Financed Part 3: Capital
#3. OE > 25% in first 10 years of farming; OE > 50% after first 10 years of farming.
For more on this: How to Get Financed Part 3: Capital
#4. Don’t compromise your operational goals.
Have a great day!
Grant
