By Michael Langemeier
How much debt can a farm carry? Although the question is too general for a specific response, guidelines can be provided for certain debts where repayment terms are known. Important factors to consider when estimating the amount of debt that can be repaid and the amount of debt that a farm is comfortable with include current liquidity and solvency positions, repayment capacity, length of repayment period and interest rate, stability of income, skill and experience of each operator, age and health of operators, and an operator’s risk aversion level.
Farms with solid liquidity and solvency positions have more flexibility regarding increases in debt levels. A farm with a solid liquidity position has sufficient current assets to cover current liabilities, as well as a potential increase in current liabilities.
A farm with a solid solvency position has sufficient current and noncurrent assets to cover current debt obligations, as well as potential increases in debt levels. In general, a current ratio above 2.0 and a solvency ratio below 0.30 are indicative of strong financial positions.
Measure repayment capacity
Repayment capacity measures include capital debt repayment capacity, capital debt repayment margin and replacement margin. Capital debt repayment capacity and capital debt repayment margin address a farm’s ability to repay operating loans and to cover the current portion of principal and interest due on noncurrent loans such as on a machinery, building or land loan.
The replacement margin enables borrowers and lenders to evaluate whether a farm has sufficient funds to repay term debt and replace assets. For a farm to grow, it’s essential that the replacement margin be large enough to repay term debt, replace assets and purchase new assets. For this to occur, the long-run average replacement margin must be positive.
The longer the repayment period and the lower the rate of interest, the greater the debt that can be carried by any level of funds available for loan repayment. It’s important to compare the life of an asset to the length of the loan used to help finance the asset. If the loan length is substantially less than the life of the asset, repayment capacity diminishes.
Income risk varies widely among farms and enterprises. Price, weather and disease all impact risk levels. When heavy debt loads are necessary, a farm should reduce these risks as much as possible. The greater the weather or price risk for the farm’s enterprises, the more conservative the amount of loans should be.
Where crop and livestock insurance can be used to reduce risk, its use should be considered. Also, the greater the risk, the greater the importance of doing things right. When everything is done well and on time, prospects for success are greatly improved, and risk is reduced.
Skills, management matter
The value of each operator’s skill and experience is important. Superior performance resulting from excellent management may be the most important factor influencing debt-carrying capacity. Superior management will cause income prospects to improve and reduce the possibility of losses.
Younger, more ambitious operators, who also have the advantage of good health, can expect to meet relatively heavy debt-repayment demands compared to anyone lacking in health and vigor. Young operators are often relatively more interested in expansion. When an operation is aggressively expanding, it is imperative to gauge the impact of this expansion on the farm’s liquidity, solvency and repayment capacity positions.
Debt and risk
Debt is one of the largest sources of risk, which relates to income volatility. Operators averse to risk tend to have lower debt-to-asset ratios. These lower debt-to-asset ratios often reduce the rate of expansion. However, they also may reduce the probability of large losses and the anxiety often associated with high debt levels.
As noted, there are numerous factors affecting a farm’s debt-holding capacity. It is important to remember that financial leverage or debt directly affects a farm’s growth rate through its effect on expected returns and risk. If a farm’s return on assets is larger than the interest rate on borrowed funds, financial leverage will increase the return on equity and the sustainable growth rate.
However, financial leverage also increases risk. For this reason, each farmer needs to weigh the benefits, in the form of higher returns and farm growth, and the costs, in the form of higher interest costs and increased risk, of financial leverage or debt.
Langemeier is a Purdue University Extension agricultural economist and associate director of the Center for Commercial Agriculture.