How much debt can a farm bear?
Relatively high profits in 2020 and 2021 are prompting many farm families to consider their options for expansion. Expansion plans typically involve the use of a farm’s retained earnings, equity, and / or debt.
Important factors to consider when estimating how much debt can be repaid and how much debt a farm operation is comfortable with include current liquidity and solvency positions, repayment capacity, length of the repayment period and the interest rate, income stability, skills and experience. of each operator, the age and health of the operators, and the risk aversion of the operators.
Farms with strong liquidity and solvency positions have greater flexibility in the face of rising debt levels. A farm operation with a strong liquidity position has sufficient current assets to cover current liabilities as well as a potential increase in current liabilities. A farm with a strong solvency position has enough current and non-current 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 a strong financial position. It is important to note that the optimal solvency ratio for a farm is closely related to risk aversion.
Measures of repayment capacity include principal debt repayment margin and replacement margin. The principal debt repayment margin takes into account a farm’s ability to repay operating loans and cover the current portion of principal and interest owed on non-current loans such as a loan of machinery. , construction or land. The replacement margin allows borrowers and lenders to assess whether a farm has sufficient funds to pay term debt and replace assets. For a farm to thrive, it is essential that the replacement margin be large enough to repay debt over time, replace assets, and purchase new assets. For this to happen, the long-term average replacement margin must be positive.
The longer the repayment period and the lower the interest rate, the greater the debt that can be supported by any level of funds available for loan repayment. It is important to compare the life of an asset with the length of the loan. If the term of the loan is significantly less than the life of the asset, the repayment capacity decreases.
Also, even if a farm could pay off a loan for a long-term asset in a short period of time, this may not be the best strategy. Matching the term of the loan to the life of an asset helps ensure that a farm will have sufficient funds to repay the loan.
Determination of the level of risk
Income risk varies widely among farms and businesses. Prices, weather and disease all have an impact on risk levels. When a lot of debt is needed, a farm should reduce these risks as much as possible. The higher the weather or price risk for farm businesses, the more prudent 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 more important it is to get it right. When everything is done right and on time, the prospects for success are dramatically improved and risks are reduced.
The value of the skills and experience of each operator is important. Superior performance resulting from excellent management may be the most important factor influencing debt capacity. Superior management will improve income prospects and reduce the possibility of losses.
Younger, more ambitious traders who also have the benefit of good health can expect to face relatively heavy debt repayment demands compared to anyone lacking in health and stamina. Young operators are often relatively more interested in expansion. When a farm is expanding, it is imperative to assess the impact of that expansion on the farm’s liquidity, solvency and repayment capacity positions.
Debt is one of the main sources of risk due to the volatility of income. Traders who are risk averse tend to have lower leverage ratios. These lower debt ratios often reduce the rate of expansion. However, they can also reduce the likelihood of large losses and the anxiety often associated with high debt levels.
Debt and agricultural growth
Many factors affect a farm’s debt 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 risks. As long as a farm’s return on assets is greater than the interest rate on borrowed funds, leverage will increase the return on equity and the rate of sustainable growth.
However, financial leverage also increases risk. For this reason, farmers must weigh the benefits in the form of higher yields and agricultural growth, and the costs in the form of higher interest charges and increased risk of leverage or debt.
Langemeier is an agricultural economist at Purdue University Extension and associate director of the Purdue Center for Commercial Agriculture.