Editor’s note: The following was written by Bradley Zwilling, with Illinois FBFM Association and Department of Agricultural and Consumer Economics at the University of Illinois, for the university’s farmdoc daily website Nov. 18.
As the Federal Reserve has raised interest rates in response to rising inflation, the average Illinois grain farmer has various things to consider when analyzing the effect on their farm.
Using data from Illinois Farm Business Farm Management, this article will look at the current make up of debt on the farm to determine the impact of rising interest rates.
In 2021, the average total (farm and non-farm) debt on Illinois grain farms enrolled in FBFM was $925,437, this compares to $335,036 in 2002.
On the total debt in 2021, 39% was for short-term obligations. This includes operating loans, accounts payable, accrued interest on all loan terms, Commodity Credit Corporation (CCC) loans, the current portion due in twelve months on intermediate and long-term loans, etc. that typically have one-year or less term.
Another 11% was for intermediate-term loans (includes vehicle loans, machinery loans, grain bins, etc.) that typically are from more than a year to seven years.
The final 50% is long-term obligations (includes farmland, homes, farm buildings, etc.) that have the longest term of greater than seven years.
As interest rates increase, the first impact to the farm is on operating loans as they can only be one year at a time. Therefore, the amount of interest paid on operating loans will increase the most in the short term. In addition, with rising operating expenses forecasted for the rest of 2022 and 2023, this will likely increase the amount of operating debt needed, also increasing interest paid.
Current intermediate-term notes will not be affected if the interest rate was locked in. However, as farmers purchase equipment, they will need to consider the rising interest rates in addition to the rising value. Capital budgeting for machinery will help you plan out your needs and be able to plan for replacement of equipment when needed. However, these added increases may lead to delays in those plans, so now is a good time to either start or reevaluate a long-term capital budget for machinery purchases to manage any extra interest cost.
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Like with intermediate-term notes, current long-term notes will not be affected if there is a fixed interest rate. If long-term assets are purchased such as land or buildings, those will now have a higher loan payment due to the rise in interest rates.
Even though new loans will have higher interest rates, farmers have held onto cash over the last couple of years due to higher incomes, leading to increases in working capital. Another way to express working capital is the current ratio. The 2021 current ratio of 3.32 was the highest since 2012.
The cash portion of this working capital can be used to mitigate the increased interest rates in the near term by paying operating expenses and down payments on new purchases to allow for less funds to be borrowed at higher rates. However, if interest rates continue to rise over a longer period and incomes decrease, working capital could be needed to offset current liabilities.
Another point of data to look at is interest paid as a percentage of farm gross revenue from 1982 until 2021 for Illinois farms. During this 40-year window, we have seen interest paid as a percent of farm gross revenue as high as 14.6% in 1983 and as low as 2.6% in 2021.
While this measure is not only affected by the amount of interest paid but also farm gross revenue, long-term, multi-year averages can remove some of the variability over time. The most recent 20-year average (2002-21) for interest as a percent of gross farm revenue was about 4%. This compares to the last 10-year average of 3.6% and the 40-year average of 6.8%.
Even with rising interest rates and increasing loan values leading to higher interest expenses, interest as a percentage of gross revenue has been declining due to higher gross revenues.
Rising interest rates will have an impact on farms. Farm operating loans will be affected first for most farms leading to higher interest expense. As farms acquire machinery, land and buildings with debt, more non-current debt will have higher rates leading to larger interest expenses for many years.
However, working capital can be used to help minimize the amount of debt needed, especially when considering long term loans at higher rates.
Over the last 40 years, interest as a percent of gross farm revenue has been decreasing and has averaged about 4% over the last 20 years. Farm interest has been a small portion of gross returns and will continue to be until more of the intermediate- and long-term loans on the balance sheet have a higher interest rate due to new purchases.
If purchases of machinery, buildings and land are not needed, continue to increase working capital during profitable years to help with down payments as well as larger loan payments when purchases are made.
Each farm will be impacted differently due to rising interest rates, so good recordkeeping and understanding of your financial statements will help you move your operation forward during this period of higher interest and volatility.
