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One of the biggest news stories of the summer in the U.S. has been Standard and Poor's (S&P) downgrading of the U.S. national debt from AAA to AA+ and the potential fallout for the financial community, namely the stock and commodity markets.
So, if you were to apply the same model of grading for your farm, how would your operation stack up? First of all, what's it matter?
"Credit rating are important for a couple of reasons. First, it is useful to track a credit rating for an individual firm or group of firms over time to ascertain their ability to handle adverse conditions," according to Kansas State University Extension ag economists Allen Featherstone and Michael Langemeier. "Second, interest rates can vary substantially depending on a firm’s credit rating."
The S&P model of grading, from AAA to CCC, is a measure of credit risk that puts together liquidity ratios, profitability ratios, repayment capacity and other key variables that indicate a business' overall financial health.
"Firms with a 'B' rating are typically assumed to have the capacity to meet credit obligations. However, adverse conditions could impair their ability to meet credit obligations," according to a recent report by Featherstone and Langemeier. "Firms with a 'CCC' rating are vulnerable to nonpayment. Ability to meet credit obligations for these farms depends heavily on business and economic conditions."
The "probability of default" or likelihood that loans will go unpaid, is the key number gleaned from any analysis of a business' state of affairs using the S&P metrics. For the AAA credit rating, the probability of default range is from 0 to 0.02%. On the other end of the spectrum, a CCC- rating shows a probability of default of 14 to 16.70%.
Featherstone and Langemeier applied this measure to Kansas farms recently and gleaned that the majority of the state's farms (just over 62%) fall in the BB- to BB+ range. Ten percent of the state's farms surpass the BBB- rating. Among farms in the state of Kansas, the probability of default was highest -- just over 3.0% -- in 1985. The 2010 level, around 1.7%, was the lowest since the late 1970s.
What's farm type got to do with your credit rating? Quite a bit, according to Featherstone and Langemeier's research. For 2010, livestock operations showed the highest probability of default: Beef and dairy cattle producers, including cow herds, beef backgrounders and dairy operations, showed probabilities higher than 2%. And, the study showed the larger and more diversified a farm is, the better its ability to repay debt.
"The non-irrigated crop, irrigated crop, crop/cow herd, and general farm types had probabilities of default below 2%. In contrast, the crop/beef, crop/beef backgrounding, cow herd, and dairy farms had probabilities of default above 2%," according to Featherstone and Langemeier. "Farms typed as 'general farms' tend to be large and diversified while farms typed as crop/beef typically have crops, a cow herd, and a stocker or backrounding enterprise. The crop/beef, and crop/beef backgrounding farms exhibited the highest probabilities of default in 2010."