Martin and Peg Smith Case

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1 Martin and Peg Smith Case Introduction The end of another year was quickly approaching. As was typical at this time of the year, Martin and Peg were gathering financial information for their mid-november meeting with their accountant to review year-ending tax management strategies. As Martin organizes the financial data for Calamity Farm, the evidence is mounting that it has been a pretty good year. Sure prices are low, but crop yields this year were above average. There were also additional government payments. Reflections from the Past Year The process of gathering the financial data for the meeting with their accountant was causing Martin to mentally replay the events of this year. Things started well. Martin could not remember a better spring for getting the crop planted. Since they were farming more acres than in the past, this was a real blessing. However, even with the good weather, soybean planting was not completed until mid-june. Fortunately, the favorable weather continued all the way through harvest. Crop and Livestock Enterprises The crop enterprises on Calamity Farm include corn, soybeans, wheat, hay, and pasture. The low commodity prices for corn, beans, and wheat are a concern, and Martin has been looking for opportunities that provide better margins. Martin is currently raising seed wheat for a local seed company and it appears that Martin will get a contract for 50 acres of popcorn next year. Popcorn will be a new experience for Martin, but he is convinced that production of specialty grains is something that will be important to future success. While popcorn is not a new specialty crop, Martin thinks it will provide a good opportunity to enlarge his specialty crop production. He takes pride in producing a high quality crop, something that is critical in popcorn production, and this contract may be a way to get paid for his extra effort. Crop production for this year included: Owned/Cash Rent Share Rent Yield Corn 700acres 60 acres 175 bu/a Soybeans bu/a Wheat bu/a Alfalfa/Grass Hay 24 4 ton/a Pasture 60 NA 1,554 acres 120 acres 1

2 While yields this year were very good, weather patterns have made the yields quite variable. Martin uses crop insurance to protect against yield risk. Every year Martin reviews his alternatives in order to select the type of coverage that would be most appropriate. "There continues to be new products and the premiums are always changing. It really can be confusing at times. I had Multi-Peril Crop Insurance following a recent drought, but this year I went with minimal coverage that included catastrophic coverage and hail insurance on corn. However, the premiums have changed again so I'll carefully review my options again this year. At this point, I don't know what I will do," Martin stated. "Yesterday my lender indicated that I should consider increasing my coverage." Additional information on corn, soybean, and wheat yields is presented in Exhibit 1. Long-term yield information is available on three farms, #1, #2, and #3, as well as the overall average for the farm. The three individual farms are ones which they have operated continuously. The only livestock is a cow-calf enterprise of cows. With the sale of two cull cows for a total of $1,000 this year, there are only 20 cows in the herd. The steer calves from this herd are usually finished in the feedlot. The heifers not kept for replacements are usually sold at weaning. "The cattle don't make us a lot of money, but they utilize the pasture and forage that we produce," Martin said. "If it weren't for the cattle, the pasture land would set idle. Given the cash rent we are paying on the farm, we need to get everything we can out of it. We also need to produce hay on a few of the acres to satisfy the soil conservation plan developed for the farm. The good hay that we produce we sell to people with horses. The lower quality hay we feed to the cattle. I would really like to market hay to more horse owners. That is an enterprise that still has good margins!" Marketing Martin had cash forward contracts for about 15 percent of the expected corn and soybean crops in late May and early June. He has also begun to use futures and options contracts, but a close friend had a major loss on a hedge-to-arrive contract, so he is cautious. Like many farmers, Martin thinks marketing could be improved, but where will he find the time? Machinery Over the past several years, Martin has made several changes in machinery. "With the changes this year, we should be set for the next several years," he said. The machinery replaced this year included the following: Purchase Price Borrowed Trade Allowance Cash Truck $25,500 $13,932 GMAC $10,000 $1,568 Tractor 71,400 24,423 FSC 15,000 31,977 Planter 73,950 29,694 FSC 25,350 18,906 $170,8500 $50,350 $52,451 2

3 In addition, several items of machinery were sold. These were items that were really no longer used. The net proceeds from the sale of these items totaled $28,500. The book value of these items was zero. "We still have more equipment than we really need," Martin said, "but I want to be in position to add land whenever it is available without the need to make machinery changes at the same time. This will also help us get the crop in and out in a more timely manner. We were a little stretched this year and area landowners are always watching, even on cash-rented farms. I would like to have Bill join me on the farm. If that is going to occur, we are going to need to grow. We are well-positioned to make that happen now." Tenure Currently the Smiths own 80 acres as a base of operations. They cash rent 1,474 acres of crop and pasture land and crop-share lease 120 acres. About two-thirds of their cash rented land is rented from a cousin on a verbal agreement, but the rent has been increasing each year. They have expanded their other cash rented land a little over the last five years. Total cash rent payments are $118,194 annually. The land they share-rent is owned by Peg s family. Martin is always looking for opportunities to expand the farm. Other farmers in the area are also seeking to expand their operations and there is keen competition for land to rent or buy, at least prior to the sharp decline in commodity prices. In addition, there is competition from non-farm development for land. Finances Martin and Peg suffered some financial reverses in the agricultural crisis of the 1980's, but they survived. Because of financial problems during the 1980's, Martin has avoided buying much land. Martin and Peg have an operating line of credit of $450,000. Although the lender renewed their loan last winter, some concern over earnings and repayment ability was expressed. The Smith's 4-year earnings statement is presented in Exhibit 2. Their balance sheet at the beginning of the year is presented in Exhibit 3. Labor Force Martin devotes full-time to the farm business. He is assisted by Chad Cass, a full-time employee. Chad has worked with Martin for a number of years. He currently receives an annual salary of $25,000. Chad handles much of the machinery repair and also drives one of the farm's semi-trucks as part of a grain hauling enterprise. Part-time employees are hired to assist with planting in the spring and harvest in the fall. 3

4 Looking to the Future While the weather was a pleasant surprise this year, there were other unforeseen events that were not as welcome. Fuel prices took a sharp upward jump during the summer. "Fortunately, I had most of these purchases booked before prices increased," Martin noted. However, prices remain high and Martin expects these price changes are going to add to next year's fuel and nitrogen costs. There were also new concerns about GMO crops in the food chain. While Martin does not produce any crops that are not approved for food use, he wonders what kind of changes this issue might bring to the market channel. He is also concerned how these continued reports might impact America's access to some international markets. Martin is also wondering about the future direction of the farm business. He and Peg are approaching 53. While retirement is still a ways off, Peg keeps reminding Martin that she can't wait to retire. She has a long list of volunteer activities that she would like to pursue. Her current 40-hour per week job at a local non-agricultural business keeps her too busy to participate in many of these activities. Peg currently earns about $25,000 per year and has family health insurance as a fringe benefit. Martin is not planning to retire any time soon. "I really enjoy farming and the challenges that accompany it. I plan to farm for another years. There will be several farmers in our area retiring in the next few years. I think this will present some good growth opportunities," he indicated. "Bill, our son, has expressed an interest in joining the farm on a full-time basis. This might be his opportunity." Their two children, Sally and Bill, were through college and building their own careers. Sally has a position with an advertising agency and recently transferred to New York City. At this time she has no interest in the farm or farming. Bill graduated with a degree in agriculture from the state's land-grant university a couple years ago. Bill lives at home, helps part-time on the farm, and works full-time for the local branch of a major agribusiness, earning $30,000 annually. While he enjoys his work, his longterm career objective is to join the farm business on a full-time basis. Bill liked the marketing courses he took in college and would like to help his dad in grain marketing. Bill realizes that the current farm will not support two families and any expansion will require more debt. Given current prices, the Smiths don t want much more debt. For the present time, Bill is willing to help out part-time and try to strengthen the financial position of the farm. Bill is planning to get married this winter. Sue, Bill's fiancée is from Chicago, and will complete her college degree in business in December. Sue is looking for a job in the area, but there are limited opportunities. Martin and Peg are concerned how Sue may react to the long hours and the risks involved in farming. While Martin and Bill haven't recently talked about Bill's joining the farm business, both would like to see this happen. Both are also wondering where the farm stands relative to their competitors. 4

5 Concluding Notes At the end of the year, Martin prepared an ending balance sheet (Exhibit 4). Their accountant helped them complete their tax return. A copy of their Schedule F (Exhibit 5) and a partial Form 4797 (Exhibit 6) for the year are also attached. An accrual-adjusted income statement for the year was also prepared. This income statement indicates the business made a profit. While Martin was pleased with this result, he knows that $40,000 was used for family living expenses. "With more normal yields this year and some improvement in prices, our projections indicate profits for next year," Martin indicated. "With Peg's job in town, we can really reduce the cash withdrawals from the business for family living if we need to tighten the belt further." Bill has reduced the outstanding balance on his student loans for college to $12,000 and paid off his personal vehicle. His net worth is approximately $25,000. Sue will have student loans of $19,000 and a car given to her by her parents which is worth $5,000. 5

6 Case Questions for Financial Performance 1. Did last year result in a profit of loss for Calamity Farm? 2. What measures can we use to assess financial performance? 3. How does the financial performance of Calamity Farm compare with that of similar farms? 4. What are Calamity Farm s areas of financial strength? 5. What are Calamity Farm s areas of financial weakness? 6. What changes can be used to improve the financial performance of Calamity Farm? 7. What is the estimated change in financial performance that will result from your suggested changes? 8. Did operating returns, changes in the market value of assets, or both contribute to the increase in owner equity for Calamity Farm? For the year, what was the dollar contribution of operating returns and market value to the increase in owner equity? 6