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Using Case Farms to Illustrate Risk Reduction Provided by Crop Insurance and Price Risk Tools for Western Kentucky Grain Farms

Todd Davis, Jonathan Shepherd, and Tyler Mark

Summary

A low-cost/low-debt and a high-cost/high-debt case farm are developed from Kentucky Farm Business Management (KFBM) farm record data to teach the effect of cost structure and leverage on working capital and profitability. These farms simulate the return over production costs, cash rent, accrued interest, annual principal payments and family living expense over a five-year period. The case farms illustrate that liquidity problems can only be met through increased borrowing, use of cash savings, or sales from grain inventory.

The low-cost / low-debt farm is assumed to have a current ratio of 1.35 with 50% of debt structured in long-term debt. The high-cost/high-debt farm has a current ratio of 0.80 with 50% of debt structured as current debt. These assumptions are based on the 2015 preliminary summary of 225 grain farms participating in the KFBM program.

The farms are assumed to have the same production and sales price to remove production and marketing skills from the cost-structure and leverage discussion. Farm-level yields, production costs, rental rates, family living, and debt payments are from the KFBM data. Grain prices are based on USDA forecasts. When teaching this case study, farmers are encouraged to change the price, yield and cost assumptions to reinforce their understanding that record yields / record prices can not eliminate the liquidity problems.

The risk reduction from combining crop insurance with hedging, put options or cash-forward contracting is used to numerically demonstrate the benefits of each risk tool, separately and in combination, in preserving working capital.

Details

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