The benefits of incorporating your farm to mitigate risk – with a small digression from the guys about why a high debt-to-asset ratio may not be what it seems.
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TRANSCRIPT.
Gabe: Our producer shared with us an article he hadn't seen before about how you can use the way you incorporate your farm as a way to reduce stress. Rodney, have you seen this before?
Rodney: Oh yeah. I've seen a lot of this... actually with you man, when we were the one cash grain contract that I ever had to do, so grain bins putting up grain bins.
Gabe: Grain bins, okay, yeah.
Rodney: Yeah, right. So back in the day in exchange for offering grain to us, we were able to offset a significant portion of the cost of a grain bin for a farmer. So I did a number of these deals.
Rodney: The credit app itself I remember, I'm just the dumb grain guy, so I wasn't that into credit stuff, and sure didn't have any credit at the time. And it relied heavily on these debt-to-asset ratios.
Rodney: I guess I would've thought that good farmers had a good debt-to-asset ratio, and bad farmers had a bad debt [crosstalk 00:01:17]. Yeah, that's when I learned that finance is not profit, those are two completely different things, right?
Gabe: That's right.
Rodney: And so anyway, what I was seeing was guys with high debt-to-asset ratios, which is good, no bad, a high debt-to-asset ratio would be bad.
Gabe: Let's talk about what that means. So a high debt-to-asset ratio means the total of your debts... like one, what you want is at a minimum, your debts to be less than what your assets are worth, right?
Rodney: Mm-hmm.
Gabe: Equal to or less. So a common event is I go buy farmland, and I got to go put, whatever, 30% down on that. And if that's the only transaction I do on day zero, I have an asset worth, whatever, let's say it's $100,000 worth of land, and I borrowed $70,000 to buy it. So that's okay.
Gabe: And the lower my debt is, relative to the value of that land, the more solid I'm seen as a credit risk. So as I pay down that debt, and let's say just the land value stays at $100,000, I am less risky to lend money to when I only owe $50,000 against the hundred thousand.
Gabe: But there's a lot of lower cost money available to purchase land. And if you're doing well at farming, it plateaus at scale businesses. So oftentimes adding another thousand acres may be better than adding 900 or 1100 because it optimizes against your current equipment set up, and staffing, and all those types of things.
Gabe: So there's an incentive if you're going to be farming for a while, and you're running at scale, to continue to grow your operation. But generally that's going to mean taking on more and more debt against your assets.
Gabe: So the reason why you see good farmers with a high debt-to-asset ratio is because they're successful in farming, they've had enough cash to put down against additional land purchases, so are buying more land, but then they're accruing more debt with that. And farming has cashflow off of it.
Gabe: In general, the cash flows are pretty good to help cover those debts. When you start to... Boy, we're going deep, or at least going deeper than expected.
Rodney: That's good, let's do it.
Gabe: So when we look at crop insurance, crop insurance, and its costs being subsidized, significantly de-risks a farming operation, not just from paying off operating loans, but fundamentally if you're a bank loaning money to a farmer to buy land, you want them to be in crop insurance because that way the cashflow keeps coming in to pay against not only operating loans, but also the cost of any debt on the land itself.
Rodney: Well in that case right there, that crop insurance becomes an asset, right? I assume as soon as you sign that insurance, you have an asset-
Gabe: That's right.
Rodney:... which is that crop insurance guarantee, right?
Gabe: That's right. Mm-hmm.
Rodney: Which at some point is offset by yield.
Gabe: Right. I don't know if the lenders look at it that way, but I think that's a fully appropriate way to look at it in practice.
Rodney: So the incidents where I've seen this happen is, a lot of these farmers like farming is their life, so there's no difference between the row crop operation, the hog operation, maybe the kid does some sort of a... what was your mom?
Gabe: Landscaper.
Rodney: Landscape. Maybe they have a landscaping business on the side; they're just set up to do these multiple things. And what happened, I remember back at some point was the farmer started saying like, "Hey man, I have a lot of risk on the table, right? Like I have a ton of cash I'll outlay in these things, I would like to separate out some of these businesses to make sure that if something goes wrong in one area... like if my hog operation goes bad, I certainly don't want it to bring down my row crop, and my landscaping, and my personal operations."
Rodney: So what I've seen a bunch of guys do is set up these individual LLCs that... And in one case in particular, back the grain bin program through our former employee, that I filled out this debt-to-asset ratio, and this LLC had no assets at all. It was 100-
Gabe: It was all debt.
Rodney:... percent debt. Like he had just structured his debt into one LLC.
Gabe: So basically he had moved all the debt into the LLC, and moved the ownership of the land somewhere else?
Rodney: Exactly. Right. And it was a protection issue, right?
Gabe: Yeah.
Rodney: We did not give him a grain bin.
Gabe: I will say most of the farmers that I've gotten to know closely, like they generally have pretty good relationships with their accountants. Not just for that reason, but obviously farming can get incredibly complex around taxes.
Rodney: Yeah.
Gabe: I was talking to a guy one time and he said, "You know, Gabe, sometimes I'm not sure if I should have gotten into farming, and then I looked at my tax bill this year and what my income was, and I felt pretty good about it."
Rodney: Nice.
Gabe: So like anything else, it's a system, it's set up, but people should, like you need to lean on those experts to extract that.
Rodney: Wait, wait, wait, wait, wait... He was excited that he didn't pay taxes?
Gabe: I don't know how much he paid, but his tax rate, I think it was pretty low-
Rodney: The rate.
Gabe: ... versus what his actual income was for his household.
Rodney: Yeah.
Gabe: And he's one of these guys that has a couple different things going on, and whatever else, so...
Rodney: A Schedule F man, Schedule F is the key to a lot of things. It's like the holy grail. And I joke about it, right, but it's because farming is a lifestyle, right? It's everything. Like you go buy a four wheeler, that four wheeler may be used for fun, but it is also used for work on the farm in a lot of cases, right?
Gabe: Yep, running out, mending fence, chasing down cattle... yeah.
Rodney: Yeah, all those hard things that we don't do on our farms. But yeah-
Gabe: Well yeah, I don't do a lot of them out here just-
Rodney: Spraying.
Gabe: ...outside of Boston.
Rodney: Yeah, more like spraying, more like spraying, spraying fence rows or something like that. But yeah, it gets used, so deductible for sure.
Gabe: Right, I remember-
Rodney: Yeah, go ahead.
Gabe: Well, I was just going to say, I remember the first time I saw cattle get out of a fence, like they broke it down. And I was at the shop, and all of the sudden I saw two hands just sprint to four wheelers because the cattle were just going.
Gabe: And I'm like, "What is going on?" Yeah, apparently wasn't the first time.
Rodney: Ah, no.
Rodney: We had pasture at our house, and we used to keep cattle for other people. And apparently part of that, whatever money changed hands, which I assume was a small amount, also met we had to chase down the cattle when they got out. And I remember doing that. Yeah, that was fun.
Rodney: Always five in the morning, always cold. Fact.
Gabe: Fact.
Rodney: Farm facts.
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