Back to the Future: Side-by-Side Relationships
Back to the Future: Side-by-Side Relationships
By Dr. David Kohl
Those who recall the movie Back to the Future will remember the drama, humor, and the outcomes of traveling in a time machine. In the decade of the 2020s, the economy has been eerily similar to the 1978 to 1979 time period. The similarities between both periods include high headline inflation as a result of oil and energy shocks, international agricultural marketplaces on the cusp of a major slowdown, and political and military strategy in a state of flux. In the 1970’s, the cure to the dragon of inflation breathing its fiery outcomes on real wages and wealth was to raise interest rates at an accelerated pace. The outcome was two nasty recessions and a farm and manufacturing economy in disarray.
To manage this current inflation and interest rate cycle, let’s draw upon some of the wisdom and strategies of the past from both lenders and producers who experienced those times. The following are some suggestions that can be customized to your particular situation.
First, lenders at that time required annual financial statements, but it was basically just a balance sheet. Today, a combination of balance sheets, profit and loss statements, and, most importantly, cash flow statements are more suited for these economic times. Monitoring the cash flow based on inflated revenues, costs, and subsequent margins is a method to manage inflation and the interest rate cycle that we are experiencing. Abrupt changes, including increases or decreases in any variable, can quickly impact bottom line margins.
Spreadsheets are a key tool for today’s agriculture manager, rather than the handwritten statements and calculators used in decades past. Regardless of the method used, financial sensitivity testing of prices, production yields, expenses, and interest rates establishes the guardrails for outcomes that can avert getting into the financial ditch.
In the 1970s, agricultural lenders moved from being order takers of minimal information to working with customers and discussing how inflation, deflation, and interest rates impacted the bottom line and key financial ratios. Producers who were receptive to those practices discovered that it made them better business managers and it also improved the lender's skill in better managing the customer's credit and the overall loan portfolio.
Reviewing the numbers and taking time to discuss scenarios, options, and alternatives was similar to the Apollo 13 spaceflight or Flight 232 in Sioux City. Sometimes in a desperate situation, you have to think outside the box. The situation might require a debt restructure with a Farm Service Agency (FSA) guarantee, or a producer might need to liquidate assets or scale down their operation. Success is not immediate and requires mini victories such as meeting payments on time or a slight profit after years of losses.
In the 1980s, a role I played was conducting many of the financial education programs sponsored by lenders and businesses in the agricultural community. In yesteryear, Cooperative Extension was a key component in educating producers. However, today, these resources have been scaled down or are almost nonexistent in some areas. The result is third-party consultants and even retired lenders are now using their years of experience and wisdom to fill this void in education.
Positioning for Abrupt Economic Cycles
To position for abrupt economic cycles, good to excellent accounting records on farm operations are still essential today. In the 1970s and 80s transition, it was often the spouse working with the owner, manager, and the lender that provided some confidence in the business financial records and the direction of the business financials. Today, there are more accountants, bookkeepers, and chief financial officers (CFOs) employed on farms and ranches. Regardless of who is in control of the financial ledger, ownership and understanding of the numbers is critical.
Communication skills between the borrower, lender, and outside resources is a key strategy. Often, emotions run high from the excitement of highly inflated commodity prices to disillusionment with highly inflated costs and the possibility of net income or net worth losses. I recommend that all stakeholders complete a personality profile as a best management practice when navigating through the economic whitewater. This assists one in understanding how others approach a situation and react to outcomes.
As a third-party facilitator in lender and customer situations during the 1970s and 1980s, individuals who were receptive to advice and lenders who were empathetic, but firm and fair often resulted in a positive outcome.
Three Level Depth Chart
Positioning for abrupt economic cycles can be analogous to playing defense in football. We will focus on three levels of defense.
The defensive line is the first level of defense, and that is analogous to profits and cash flow in a farm business. What is being done to bolster this line of defense? Knowing the cost of production, breakeven levels, and employing a marketing and risk management program would be top of the list. Off-farm or “gig” income to bolster cash flows and better utilize assets, whether it is a capital or human asset, could be another strategy.
The second level of defense is working capital or the top half of the balance sheet, similar to a good team of linebackers. This is usually the choke point where financial adversity occurs for a household, business, or nation. The best working capital is generated from profits and cash flow and stored on the balance sheet. A debt refinance or restructure using equity is a secondary strategy. Each time you refinance, it places a linebacker on the sidelines, thus you have fewer options. Both lenders and regulators who oversee them become increasingly conservative the more the refinancing option is used.
The third level of defense is collateral or equity. During the 1970s and 80s there was an environment of high inflation, interest rate increases, and then declining land values, by as much as 50 percent in some regions of the country. Coupled with losses on the income statement, equity was quickly depleted, particularly for the highly leveraged baby boomer farmers and ranchers who were just entering the business during that time period. Fast-forward to today and balance sheets are strong, even with the value of the assets being inflated. The baby boomers who survived are now later in their business cycle, which does provide some resilience.
As the Back to the Future time machine comes full cycle, a few of the practices for both borrowers and lenders transcend time periods. Relationship lending focused on financials makes both borrowers and lenders better. Sound financials with producers taking ownership and accountability along with educational programs designed to improve the skill sets and growth are a win for both borrowers and lenders. Finally, strap on your financial helmets and get ready for a three-level team approach centered around profit, cash flow, liquidity, and equity for growth, preservation of wealth, and the well-being of the business, family, and personal life.