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Financial Shock and Stress Testing

 

The other day a young producer was concerned because he had difficulty obtaining his operating loan for yearly operations. He stated that the lender performed financial shock tests that raised concerns about his financial status. Let’s examine some of the financial shock tests that are top of mind with your lender, and particularly the regulators that provide oversight on agricultural loans.

 

Cash Flow Tests

As you project your cash flow, conduct a simple financial shock test by decreasing revenue projections by 10%, holding expenses and interest rates constant. If you do not have crop insurance or a risk management plan in place, increase the revenue shock to 20%.

Next, increase input costs by 10% and 20%, holding revenue and interest rates constant. This case demonstrates what could happen given the occasional replanting or a sudden rise in feed costs. Many producers are developing input purchase plans to reduce volatility in this area.

Finally, shock test interest rates by increasing them by 1%, 2% and 3% on variable rate loans, holding revenue and input costs constant. By shocking revenue, input costs and interest rates you can plan for these potential scenarios by thinking through actions to take to protect cash flow if these scenarios play out.

 

Additional Stress Tests

Another shock test that lenders often conduct is calculating breakeven metrics on the most prominent commodities or products produced on the farm or ranch. Peak performing producers often conduct enterprise analysis by calculating breakeven metrics.

Let’s go to the balance sheet. With sky high land values, many lenders shock test real estate assets at up to a 50% decline in value, while still maintaining sufficient collateral positions. Other lenders are limiting loan exposure on land purchases to 50% of value.

Another element lenders are stressing is sufficient working capital to revenue, which is current assets minus current liabilities divided by revenue. This is a secondary backup in case there is a hiccup in profits or cash flow. A recommended metric is 20-25% working capital to revenue.

The next time we will take stress testing to another level behind-the-scenes at your lending institution.

 

Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at [email protected]