One of the key financial ratios that agricultural lenders use to determine repayment ability is the term debt and lease coverage ratio. It measures the amount of debt obligations (debt service which includes principal and interest), compared to the debt servicing capacity (net income plus interest and depreciation). For example, if a farm has net income of $60,000, plus interest paid of $15,000, and depreciation of $25,000, the debt servicing capacity would be $100,000. If the living costs and taxes are $60,000, the capacity would shrink to $40,000. If the principal and interest payments (or debt service obligations) are $30,000, then $40,000 capacity divided by $30,000 debt service would result in a coverage ratio of 133 percent. This means the producer can cover all of their debt obligations with 33 percent of their capacity left over. A coverage ratio less than 100 percent means current debt obligations cannot be fully met.
How would this example farm stack up to the average of all farms on the FINBIN Farm Financial Database? It would fare quite well because the average coverage ratio for farms was a miniscule 101 percent in 2013. This is contrasted to three years prior when the average on the FINBIN database was 336 percent. A study of this ratio since 1996 finds that the average over this period of time was 189 percent. It is quite obvious that strong profit years since 2006, with the exception of 2009, have influenced the level of this ratio, making a very comfortable environment for both producers and lenders regarding repayment ability.
As prices moderate, particularly grain prices, these ratios will have to be monitored very closely. The 2013 data suggests that if the average was 101 percent, barely covering debt obligations, then softening prices in 2014 will result in less than 100% coverage, placing the role and the importance financial working capital in the spotlight as a backup measure. On the other hand, more farms that are diversified with crop and livestock enterprises or those that just specialize in livestock may produce some very strong numbers. Only time will tell.
The challenge to producers will be to monitor their coverage ratio level and communicate with their agricultural lender. Generally speaking, when this ratio drops below 125%, lenders become cautious. A coverage ratio below 100 percent for multiple years requires action. One option is to add non-farm income or have other business revenue sources to bolster the repayment ability. Another option is to request refinancing or stretching out the terms of repayment as a means of lowering the payments, thus increasing the ratio. One of the well-respected farm management instructors in Minnesota uses the coverage ratio as a means of examining overall marketing and risk management programs to determine various breakeven yield, cost and price thresholds.
The bottom line is that coverage ratios are being squeezed and must be closely monitored by ag lenders and producers. This will be an interesting year to examine the coverage ratio to see if 2013 was an aberration or if lower coverage will be a longer term trend.