Repayment risk in a variable economic environment

No one knows what is ahead for 2015, but history tells us that there is no such thing as a “new normal” or a new plateau in agriculture. These terms were frequently mentioned when talking about the grain industry over the past decade, and now they are being discussed in the livestock industry as the economic tables turn.

Lessons from the past find that the stress point in business financials is repayment capacity given debt service commitments. Repayment capacity and the management factors that influence it should be front and center in many producers’ game plans. This is because of the variable economic environment that is showing suppression of grain prices, possible interest rate increases, and the constant cost creep due to inflation. Even in the livestock sector with favorable returns, focusing on repayment now will be critical to prepare for when the cycle takes a downturn.

Let’s take the mystery out of repayment capacity, a major factor that lenders will be focusing on in end-of-year analysis and the upcoming renewal season. To calculate it, simply tally up your business and non-business revenue, and deduct all expenses, which will result in net farm income. Then add interest and depreciation (a non-cash expense) to net income. Deduct living expenses and income taxes. This calculation results in repayment capacity available for debt service. Subtract debt service payments (principal and interest) to determine the margin. To calculate coverage ratio, simply divide your debt service by repayment capacity.

Hopefully, the calculation finds the coverage ratio is 100% greater, indicating a positive margin. In a variable economic environment, it is important to then conduct financial sensitivity analysis.

  • How would reduction of prices or production affect the bottom line?
  • If 50 percent of new crop grain or livestock is forward priced, leaving the remainder subject to the variability of the market, how does this impact your bottom line?
  • What happens if a 10 percent lower rental or lease arrangement on farm ground is negotiated, or if you take a cash discount on crop or feed inputs?
  • What if family living withdrawals are curtailed by 10 percent? How would this impact the bottom line?
  • What would happen to the coverage ratio if interest rates were increased 1 percent on the operating debt 2015?

The table below can be used as a tool for evaluating changes in strategy and management as well as communicating changes to business partners, spouses, and lenders in this variable economic environment. It can also be a great communication tool for explaining projections based upon your track record.

In this example, you will notice in 2014 the producer had $100,000 margin and 200 percent coverage ratio (or $2.00 of capacity for every $1.00 of debt service). However, projections for 2015 with $3.00/bu. corn, $9.00/bu. soybeans, and $4.50/bu. wheat illustrate breakeven repayment capacity concerning price, holding all other costs, living and debt service in line. As a producer, now you have the boundaries established for your production, cost of living withdrawals and debt service, so that logical instead of emotional decisions can be made. Now one can go down the adjustment protocols to tweak the bottom line just like a quarterback observes different defenses and goes through a protocol list.

 

Next time I will discuss what to do when repayment capacity fails!

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