Financial Analysis of an Agricultural Business – Repayment Ability
Farm Business Management Update, April 2008 - May 2008
Alex White (email@example.com), Instructor, Agricultural Finance and Small Business, Agricultural & Applied Economics, Virginia Tech
Repayment ability measures the ability of a farm or small business to generate enough cash throughout the year to cover the regularly scheduled loan payments. This is a critical factor in the success of any farm or smalln business. As you might expect, lenders are very interested in measuring a farm’s ability to repay their loans. But managers can use this aspect of financial analysis to improve their operation.
I like to use the debt coverage ratio to measure repayment ability. This ratio measures the ability to make the regularly scheduled debt payments; it also helps identify several potential strategies for improving the cash flow of the business.
The debt coverage ratio compares the net cash income before loan payments generated by the business and household to the regularly scheduled loan payments for the year. This ratio includes all of the cash coming into the business and household throughout the year, including non-farm income. It also includes all of the cash expenses of the business, family living expenses, and income tax payments.
Here’s how to calculate the debt coverage ratio:
First, start with net farm income from your income statement. Next, you add back the total interest expense and depreciation expense for the year. You add interest expense back because we are trying to determine how much cash your farm is generating to make you loan payments (principal and interest). Add depreciation expense back because it represents a non-cash expense. This subtotal is essentially your net cash income before interest. Next, you add in any non-farm income because this cash can be used to repay loans.
The final adjustments are to subtract your family living expenses and your annual income taxes paid. The resulting figure is your debt coverage margin, which measures how much cash you have available to apply to your term debt payments. Obviously, you want your debt coverage margin to be greater than you annual debt payments.
To calculate the debt coverage ratio, simply divide the debt coverage margin by your annual debt payments. Like all ratios, the benchmark depends on your enterprise or your industry. In general, I like to see this ratio greater than 125% -- this would indicate that you are generating $1.25 of cash that is available to make every $1 of loan payments. At a minimum, I would want this ratio to be 110% - this indicates that you have enough cash to make your payments and leave yourself about a 10% margin just in case. Remember, the higher the debt coverage ratio, the stronger your repayment ability.
What can you do if you have a low (or poor) debt coverage ratio? The debt coverage ratio is a powerful management tool because it helps a manager identify several methods of improving the cash position of the business. Here’s a brief list of the main strategies for improving your debt coverage ratio:
How can you increase your receipts? There are two main ways to increase your receipts – increasing production without increasing your production expenses, or increasing the selling price of your products through improved marketing. In Virginia, more producers will need to look closely at their marketing plans and increasing their receipts through niche marketing, direct marketing, contracting, or price risk management.
Another method of freeing up cash for your loan payments is to reduce your top five expenses. Reducing your largest expenses by 5-10% will have a much greater impact on your “bottom line” than eliminating smaller or “insignificant” expenses. For most operations, the largest expenses typically include purchased feed, fertilizer and chemicals, labor, and interest expense.
The last main method of improving your repayment ability is to restructure your loans over a longer term. Producers tend to set up their loans over too short of a time frame – yes, this does reduce your interest expense over the life of the loan and it builds your equity faster, but it also puts a lot of pressure on your cash flow. Shorter loan terms lead to higher annual payments!! My philosophy on loans is to choose a longer time frame to repay the loan – and hence, lower scheduled payments - but make prepayments when you have the available cash.
The debt coverage ratio is one of the most useful financial ratios for a business manager. It measures repayment ability, but it also provides several potential methods of improving the cash flow of the business. Try to keep your debt coverage ratio greater than 125% and you’ll be in pretty good shape.
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