What Does a New High in Farm Debt Mean for the Ag Sector?

There’s no question the credit landscape is changing: there have been four interest rate hikes from the Bank of Canada since our 2017 assessment of farm assets and debt while agricultural markets are also going through significant turbulence because of weather and trade tensions

by Amy Carduner, Agricultural Economist – FCC Ag Economics

Commodity prices have generally declined in 2018 and volatility has picked up. Within that uncertain economic and financial environment, Canadian total farm debt increased 6.6% from 2016 to reach over CA$100B in 2017.

This might be cause for concern, but Statistics Canada’s Balance Sheet of Agriculture suggests not. It paints a picture of a sector that has had the resilience to get through a patch that has been bumpier than usual.

“Canadian farm assets were valued at CA$632.2 billion in 2017, having grown 6.9% year-over-year”

I’ll look at how some financial measures from the Balance Sheet can be used to assess Canadian agriculture’s financial health, and why I believe the sector will be in good shape to end 2018 and head into 2019.

Leverage remained at safe levels

Of the four indicators of agriculture’s overall strength I’ll look at, the industry’s overall debt-to-asset ratio (DAR) improved slightly in 2017 – from a level that was already robust. It’s one of agriculture’s most-watched measures as its strength bodes well for the future health of the industry.

The DAR indicates the extent to which assets are funded by debt (and not equity). A low DAR brings flexibility such as borrowing more if opportunities arise.

Operations funding future asset purchases with more debt than equity run a greater risk of pay-back problems. Because agricultural prices are prone to cyclical behaviour and cash flows are subject to seasonal pressures, a healthy year-round DAR is critical.

The decrease in the DAR to .15 means the ag sector funded CA$1.0 of assets with CA$0.15 of debt and was right on par with its 10-year average (Figure 1). Provinces from Quebec to Alberta drove the decrease, with the DAR lower than the 10-year average in each.

The year-over-year story differs. While the DAR at the national level improved over the last 12 months, Ontario, Alberta, and B.C. each recorded an increase in the DAR from 2016 (not shown). In each of these provinces, farm debt increased at a faster year-over-year pace while asset values also increased, but at a slower year-over-year pace.

The CR indicates the extent to which an operation can cover current liabilities (debt to be paid within 12 months) using current assets (assets that can be converted to cash within 12 months).

A high ratio provides flexibility and shields a business from financial difficulties if market conditions worsen.

Another key indicator of overall health is the current ratio, measuring liquidity. Even as debt has grown, Canadian agriculture could boast of good liquidity in 2017, with enough easily-convertible assets to cover all immediate debt. The sector’s strong current ratio (CR) of 2.27 in 2017 (Figure 2) means Canadian agriculture had CA$2.27 in current assets for every CA$1.0 in current debt. Although it also represented a 2.5% decline from 2016, and was lower than the 10-year average, it was still in a range we consider healthy.

Only Quebec and Manitoba recorded year-over-year CR increases in 2017 and, along with British Columbia, had current ratios in 2017 that were higher than their 10-year average. Saskatchewan continues to have the highest CR of all provinces (3.4). That’s typical for the province because large grains and oilseeds operations dominate Saskatchewan agriculture. But even there, the 2017 CR fell below its 10-year average.

Because of price pressures on some crops, higher interest rates and farm input costs throughout 2017, current ratios for Ontario, Alberta, and the Atlantic also dipped in 2017 below their respective 10-year averages. Each, however, remains in a healthy range.

Asset value growth outpaces net income

Canadian farm assets were valued at CA$632.2 billion in 2017, having grown 6.9% year-over-year. At the same time, net income decreased slightly after commodity prices weakened, and energy and interest costs increased. The simultaneous growth in asset values and weakened net income meant that Canadian ag’s return-on-assets (ROA) dropped below its 10-year average (Figure 3).

The ROA measures profitability (i.e., net income) relative to total assets.

As with the LR level, there’s no ideal ROA. A higher ROA is preferred when debt levels are increasing as it makes it easier to service debt.

Saskatchewan, with the highest ROA in the last ten years, recorded a 21% decline in ROA in 2017, the country’s largest drop. Alberta also recorded a declining year-over-year return-on-assets and Quebec saw no change in 2017.

Elsewhere, the sector’s ROA increased from 2016. And strengthening net income improved the 2017 ROA in the Atlantic provinces, Ontario, Manitoba, Alberta, and BC to levels higher than their 10-year average.

Affordability of farmland continues to decline

Farmland values increased in 2017, totaling roughly 70% of all assets. Land prices, farm income and the relationship between the two vary across provinces but, in general, Canadian farmland, as measured by the land-to revenue ratio (LRR), has become less affordable.

The LRR measures the affordability of land using crop receipts (i.e., gross revenue from crops). Average land values and crop receipts are expressed on a per acre basis.

There’s no ideal LRR level. Crop mix and productivity influence the ratio, which therefore varies across provinces. Historical within-province comparisons assess current values more accurately.

The pace of land value appreciation has exceeded appreciation in crop receipts since 2012. Given that more rapid increase, the LRR increased to be higher in 2017 than its respective 10-year average across all provinces (Figure 4). This suggests that land is expensive from a historical standpoint, but other factors must be considered. The downward trend in interest rates for most of the last ten years, wealth effects and expectations of future growth in agriculture can explain why the ratios are higher than their average.

Conclusion

A few headwinds emerged for Canadian agriculture in 2018 and we believe Canadian ag is in good shape to weather the storm. The industry’s financials are strong despite some recent softening. And we project 2018 and 2019 revenues to approximate 2017 levels given the strength of global demand.

Understanding the industry’s exposure to possible fluctuations in the environment, whether from farm income trends levelling out or further interest rate increases, can help to avert financial hardship. By providing guidance to individual operations, that understanding will go a long way to maintain the overall health of Canadian agriculture.

Next week, find out how the currently rising interest rates will impact Canadian agriculture.

source: FCC Canada