Repayment capacity measures evaluate the ability of a farm to generate enough funds to repay the current portion of term debt payments and replace assets. Commonly used repayment capacity measures include the capital debt repayment capacity, the capital debt repayment margin, the replacement margin, the term debt and capital lease coverage ratio, and the replacement coverage ratio. This article will focus on the replacement margin, which is more of a long-run measure of repayment capacity.

The capital debt repayment margin and the replacement margin are computed in a stepwise fashion. The capital debt repayment margin focuses on a farm’s ability to repay the current portion of principal and interest on term debt. 

To compute the capital debt repayment margin, important uses of funds such as family living expenses, income and self-employment taxes, the current portion of principal and interest on term or noncurrent debt, and the unpaid portion of prior-period operating debt are subtracted from the total of accrual net farm income, off-farm income and depreciation. Though there may be occasional years in which a farm cannot cover the uses of funds previously noted, successful farms cover these uses most, if not all, years. A viable farm will have to cover these uses in the long run.

Replacement margin

The replacement margin is computed by subtracting cash used for capital replacement from the capital debt repayment margin. We typically compute the cash used for capital replacement using depreciation plus another 10% to 20% of depreciation. This amount enables a farm to replace machinery and buildings, and expand in the long run. 

For most farms, the replacement margin is not going to be positive every year. For example, for quite a few farms, this measure has been relatively low or even negative since 2014. 

Yet it’s imperative that the replacement margin is positive in the long run. Specifically, the 10-year average replacement margin for a farm should be positive. If this isn’t the case, the farm is probably not going to be able to sustain its current asset base — and certainly won’t be able to expand.         

Using data from the Center for Farm Financial Management at the University of Minnesota, about 45% of the farms included in FINBIN, a record-keeping system, had an average replacement margin that was negative during the 2009 to 2018 period. It’s important to note that there were several very profitable years during this time period. 

Farms with a negative replacement margin likely did not replace machinery in a timely fashion during the past 10 years. In 2018, about 45% of the farms had a negative capital debt repayment margin and about 55% of the farms had a negative replacement coverage ratio. These farms need to be extremely cautious with their use of cash, particularly for purchases of machinery, buildings and land.  

This article briefly discussed repayment capacity measures. These measures enable borrowers and lenders to evaluate the ability of a farm to generate enough funds to repay the current portion of principal and interest payments, and to replace assets. In the long run, the capital debt repayment margin and replacement margin need to be positive. For an example about computing replacement margin, read this related story. More information pertaining to financial management can be found on the Purdue University Center for Commercial Agriculture website.

Langemeier is a Purdue University Extension agricultural economist and associate director of the Center for Commercial Agriculture.