October 4, 2018
Repayment capacity evaluates 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. The capital debt repayment margin and the replacement margin are the focus of this article.
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 can’t cover the uses of funds noted above, successful farms cover these uses most, if not all, years. A viable farm will have to cover these uses in the long run.
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. Having said this, 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, let alone expand.
Using data from the Center for Farm Financial Management at the University of Minnesota, approximately 50% of the farms included in the farm financial database known as FINBIN in 2017 had a negative capital debt repayment margin, and approximately 60% of the farms had a negative replacement margin. These farms need to be extremely cautious with their use of cash, particularly for purchases of machinery, buildings and land.
This article briefly discusses 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, such as over a 10-year period, the capital debt repayment margin and replacement margin need to be positive. More information pertaining to financial management can be found on the website for the Center for Commercial Agriculture.
Langemeier is a Purdue Extension agricultural economist, and associate director of Purdue University’s Center for Commercial Agriculture.
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