November 9, 2022
A recent three-day conference with young and beginning farmers and ranchers brought about much energy and engagement. One question from the session was rather challenging, “As interest rates, costs, and market uncertainty rise, how should producers change our debt goals? How much debt is okay? Which type of debt should get priority: real estate, equipment, or operating debt?” Every operation is different as far as debt levels; however, there are a few guidelines and metrics that can prevent you from getting into the financial ditch.
First, one must analyze the business and specifically the individuals and spouses connected with the business to determine the overall appetite for debt. If debt is perceived to be overwhelming, particularly in times of uncertainty, emotions can vary and quickly drain business energy from positive to negative. The old rule of thumb is if your debt keeps you awake at night, it is often too much.
Now, on to the numbers. In the 1980s farm crisis, a study conducted by my good friend Dr. Ed LaDue at Cornell University found that when the debt to asset ratio exceeded 50 percent, it was the number one factor for financial stress. Additionally, countering a debt to asset ratio exceeding 50 percent requires the business to exhibit five characteristics or conditions.
With a higher level of debt, production and cost efficiency must be in the top 25 percent of a peer analysis.
A marketing and risk management program must be developed, executed, and monitored.
Family living withdrawals need to be modest when compared to peers.
Off-farm income is sometimes needed to bridge financial liquidity gaps.
High levels of overall management and business IQ must be exhibited, along with some luck and timing.
Another ratio I follow is term debt divided by EBITDA*. Term debt includes debt on land, structures, machinery, equipment, and breeding livestock. If you operate a smaller operation, you could include nonbusiness income or nonfarm income. For example, if the term debt is $1 million and net income is $100,000, nonfarm income is $50,000, interest paid is $50,000, and depreciation is $50,000, then the EBITDA would be $250,000. EBITDA divided into term debt would yield a ratio of four to one. This means that for every four dollars of debt there is one dollar of EBITDA.
Ideally, to be in the “green light” this ratio should be less than three to one. A debt level yielding a ratio between 3:1 and 6:1 is yellow or caution. A “red light” is a ratio greater than 6:1. The example above would be in the yellow light area.
Finally, your level of debt agility and resiliency is linked to financial liquidity. Attempt to keep working capital levels greater than 25 percent of expenses or a current ratio above 1.5 to 1. Finally, working side-by-side with your lender or financial consultant to refine your debt goals is another strategy that is going to be very appropriate in these times.
*EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization
Source: David Kohl, who is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.
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