The other day a Canadian ag lender was calculating the term debt and lease coverage ratio. He asked why we include off-farm income or revenue and depreciation when calculating this debt service and margin metric.
First, 70% of North American producers supplement their businesses with off-farm income. Historically, much of the off-farm income was derived through W-2 wages of spouses or operators working part-time. The recent recession has seen wages and fringe benefits slashed, which has hindered many smaller lifestyle farms’ ability to service debt.
For larger farms and ranches, many are operating complex businesses with multiple entities and enterprises. Historically, these outside businesses would generate Schedule C or Schedule K income to supplement the agricultural business. Now that agriculture is doing quite well, the table has turned in some instances. Lenders are now closely scrutinizing these other entities as third party/counter party risks, so be prepared to have a good set of financials and documentation on these other businesses.
Concerning depreciation, many producers take advantage of Section 179 of the tax code that allows for accelerated depreciation. This can distort financial ratios in the year the depreciation is written off, if the amortization principal and interest does not match the depreciation.
- In Case 1 above, off-farm income would be critical in making the payment because the accelerated method of depreciation was not used.
- In case 2 with accelerated depreciation and off-farm revenue, the coverage ratio is strong, above the 150 percent recommended metric.
Frequently on hog, dairy, and poultry operations the facilities are depreciated rapidly, which results in mismatching of the amortization schedule, which presents a false sense of security when utilizing the coverage ratio. Debt service payments are still required when the deprecation ends, which can hinder repayment ability.
Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at [email protected]