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How much debt can a farm carry?How much debt can a farm carry?

Farm Business: Know your financial position before considering expansion.

Michael Langemeier

October 7, 2021

4 Min Read
tractor and disk in crop field
CONSIDER DEBT BEFORE EXPANDING: Good crop prices may have you thinking about buying new equipment or adding land. Here’s how financial stability and debt repayment fit into the equation. Tom J. Bechman

Relatively strong profits in 2020 and 2021 have many farm families examining their options to expand. Expansion plans usually involve using a farm’s retained earnings, net worth and/or debt.

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 the operators’ aversion to risk.

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 0.4 are indicative of strong financial positions. It is important to note that a farm’s optimal solvency ratio is closely related to risk aversion.

Paying back loans

Repayment capacity measures include the capital debt repayment margin and the replacement margin. The capital debt repayment margin addresses a farm’s ability to repay operating loans and to cover the current portion of principal and interest due on noncurrent loans such as 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 is 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 is important to compare the life of an asset to the length of the loan. If the loan length is substantially less than the life of the asset, repayment capacity diminishes.

Moreover, even if a farm could repay a loan for a long-term asset in a short period of time, this may not be the best strategy. Matching loan length to the life of an asset helps ensure that a farm will have sufficient funds to repay the loan.

Determining risk level

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 loan amounts 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.

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 is one of the largest sources of risk due to volatility of income. Operators who are 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.

Debt and farm growth

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. As long as 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, farmers need 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 ag economist and associate director of the Purdue Center for Commercial Agriculture.

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