With the winter’s drop in grain prices, it’s important to track your inventory adjustment to avoid cash-flow and financing surprises
By: Craig Macfie
Canola prices, as just one example, are down approximately 25 per cent from late 2023. Wheat is down 15 per cent, meaning producer paycheques have decreased with the markets this winter.
That’s not all there is to watch for, however. Given that many farms have post-harvest year-end dates, a significant amount of inventory on 2023 farm balance sheets is likely overstated.
As a result of that overstated inventory and the grain inventory adjustment, many producers’ 2023 profitability could be inflated and 2024 worsened, with potential impacts on your cash flow and financing.
What is a grain inventory adjustment?
Unlike most businesses, farms grow their own inventory. A typical manufacturing business will have raw-goods inventory, work-in-progress inventory and finished-goods inventory. An inventory adjustment for this business should only result from theft, damage or a counting error.
Still, inventory shrinkage is a write-down and to be avoided. For these businesses, when inventory is sold, it is expensed as cost of goods sold. Revenue less cost-of-goods-sold equals the gross margin.
Since farms grow their own inventory, the inventory adjustment acts in a way similar to the cost-of-goods-sold expense and it can increase or decrease your gross margin. Since inventory is always a best estimate, producers will always see a grain inventory adjustment on their financial statements. Sometimes it will be to the good, and sometimes negative, depending on the quantity and quality of inventory and market prices.
An effective way to explain the grain inventory adjustment is to consider a farm’s first year in operation. If our fictional farm didn’t sell any inventory in its first year in operation, there would be no grain inventory adjustment. Balance sheet inventory would equal and offset the accrual grain revenue.
If the farm does sell inventory prior to year-end, however, the grain inventory adjustment will be the difference between the value of production and the inventory on hand.
This holds true for every year that follows with one additional adjustment. The inventory on the prior year’s balance sheet will also have an inventory adjustment since its final selling price will likely be different than the estimated year-end value.
Therefore, accrual grain revenue equals the value of current year production plus or minus the prior year’s inventory adjustment.
Accounting treatment
Most accountants will correctly value farm inventory at the balance sheet cut-off date using net realizable value. Net realizable value is essentially fair market value less selling costs. The balance sheet is prepared as of a point in time. This is true even under a financial statement review engagement or audit. Producers also have the option to record their agricultural inventories at cost, but most won’t find this method practical.
Financing and cash-flow implications for 2024
The main financing implication if 2023 inventory is overstated is for profitability and debt servicing. Keeping up-to-date inventory records with your bookkeeping will help you monitor your grain inventory adjustment. This will also help you get out in front of any issues with 2024 bank ratios and covenant testing.
Consider a grain farm with $1 million of inventory on hand at 2023 year-end. A 20 per cent drop in inventory value equals a $200,000 grain inventory adjustment expense for 2024, which is a direct hit to the 2024 debt-service ratio.(Fortunately, most lenders will test the debt-service ratio on a longer term average such as the past three years.)
When saleable inventory drops in value, confront the brutal truth and update your working capital and cash-flow forecast. Less money could be available for working capital, acquisitions or owner draws.
A grain inventory adjustment expense in 2024 will affect your profitability and debt service ratio before you even spin a tire in the field this spring. Producers cash-flow and operating credit will be weakened and pressured with the drop in commodity prices.
Of course, markets can always turn around but producers and their trusted advisors will be wise to be aware of potential grain inventory adjustments coming in 2024.
-This article was originally published in the April 2024 edition Country Guide
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