One of the five C’s of credit is the ability to service debt on a timely basis, otherwise known as cash flow. As the elongated downturn in agriculture continues, cash flow will become front and center in farm financial analysis. The attention to a borrower’s ability to service debt will be particularly important with the possibility of shocks in prices due to the strength of the dollar, trade sanctions, and tariffs. In the last column, we discussed the state of farm profitability, as reported by the FINBIN farm record database. In this issue, let’s examine the ability to service debt and factors influencing this key component in working with agricultural lenders.
The term debt and lease coverage ratio is the Farm Financial Standards Council’s metric that lenders utilize to gauge a borrower’s ability to service debt. The ratio is calculated by dividing the total repayment capacity of the business by the annual debt service payments. A ratio of 200 percent means that the business has two dollars of cash flow for each dollar of debt service. Since 2013, the average producer in the database, which covers approximately 20 states and thousands of farms, illustrates dismal results. The average coverage ratio over the duration was 98 percent, which shows an inability to service debt. Data in 2017 indicated that the average coverage ratio for producers was just squeaking by at 102 percent. The top 20 percent of producers generated a strong margin above 200 percent. The bottom 20 percent of producers were in a negative range. Examining historical data finds that a negative coverage ratio has been the case for the bottom tier producers for many years.
What are some possible solutions to improve the term debt and lease coverage ratio?
More producers are now on their second or third restructure of debt. They have utilized their equity to reduce annual debt service requirements. The question becomes how many more times will this be accepted by both the lender and regulators?
Other producers are seeking off farm employment. This is not only to generate extra income, but to cover those pesky healthcare costs. Health insurance premiums and medical expenses are increasing dramatically and are impacting the farm family living budget.
Some agricultural businesses are postponing equipment and facility upgrades. In a few cases, producers are forgoing capital expenditures on everything. With capital expenditures on upgrades and repairs being postponed, in four or five years these companies could experience higher maintenance costs and increased downtime.
Another method of generating extra funds is the partial liquidation of farm assets. However, one must be careful of not “eating your seed corn or seed stock.” In other words, producers need to be mindful about selling productive assets that will affect their ability to generate future income.
The term debt and lease coverage ratio needs to be on the dashboard in the next few years and monitored very closely. Positive cash flow is necessary to service debt and ensure the company’s long-term success.
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