Debt Service Analysis: Can I Repay?

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1 Purdue Extension Knowledge to Go Debt Service Analysis: Can I Repay? Low prices and incomes have made many farmers and their lenders concerned about the farmers ability to fulfill debt obligations. Lenders are increasingly asking their farm customers for documentation of repayment or debt servicing capacity. Even though financial performance may be acceptable with respect to the key performance ratios described in Table 2 and calculated using Worksheets 1 and 2, farm business managers could encounter debt servicing problems because of cash flow shortfalls or short repayment terms. So an additional task in assessing the overall financial performance of the farm business is to determine whether any difficulties will be encountered in making payments on current debt obligations. The key issue in repayment capacity analysis is to obtain the best evidence or provide the best documentation that sufficient cash will be available to make scheduled principal and interest payments. The common procedure used to provide that evidence or documentation is the seasonal or annual cash flow. But, as shown in Table 3, other forms of documentation or evidence are available. In some cases, these alternatives may be both more reliable and easier to compute. A complete repayment analysis requires documentation of the ability to repay the operating loan in a timely fashion and of the ability to make scheduled principal and interest payments on the term (intermediate and long-term) commitments. The documentation or management of repayment capacity can come in three different forms: 1) repayment ratios/measures, 2) operational strategies, and 3) cash flow projections (discussed in the next section). Repayment Ratios Worksheet 3 (p. 18) guides you in computing the repayment capacity measures described in Table 3. You can figure the five repayment measures in Table 3 after the fact using actual performance data. You can also compute them using estimated or projected revenues, expenses, and cash flows. Because the data called for in Worksheet 3 is primarily historical data, the worksheet measures whether the farm had repayment capacity last year and whether the farm currently has enough Table 3. Alternative Methods of Repayment Documentation Type of Obligation Repayment Ratios/ Measures Cash Flow Operational Strategies 15 Operating loan/short-term current obligations Current ratio Working capital Seasonal or annual cash flow budget Cash/resource reserves Assignments Contracting/forward pricing Term debt/long-term obligations Term debt coverage ratio Term debt repayment capacity Term debt repayment margin 3-5 year annual cash flow budget Hedging Insurance Controlled spending

2 Measuring & Analyzing Farm Financial Performance 16 liquid assets to pay current obligations. Using data from a projected income statement, you could recompute Worksheet 3 to estimate whether the farm shows repayment capacity for next year. With respect to repayment ratios or measures, the current ratio indicates the dollars of current assets that are available on the balance sheet date for every dollar of current liabilities on that date. The current ratio is indicative of the farm s ability to pay current obligations as they come due, and thus it is generally classified as a measure of current liquidity. Working capital is determined as the absolute dollar value that current assets exceed current liabilities and reflects the margin or cushion in short-term debt service capacity in absolute terms. Both the current ratio and working capital measures are stock concepts. That is, they take stock of the current assets and liabilities on the balance sheet date. As a result, their usefulness as indicators of repayment is limited to the very near term. The money that must flow out of the farm business during the next year in order to meet obligations may far exceed the working capital on the beginning balance sheet date. In general, the most useful measures of repayment capacity will take into account both the stock of working capital and the expected flows of money that will go in and out of the farm business during the next year. The debt coverage ratio indicates the net income (not cash flow) from the farm business that is available annually for every dollar of principal and interest payment on term debt. Term debt repayment capacity is an absolute measure of the dollar amount of repayment capacity. Both measures, like the current ratio and working capital, provide alternative ways of looking at the same financial information. The debt repayment margin measures how much of the term debt repayment capacity remains after the scheduled principal and interest payments have been made. These measures take into account money flows during the year, so they are more useful predictors of repayment ability than liquidity measures. Preferably, you should compute these measures using net income based on accrual-adjusted revenues and expenses. That way, they will reflect changes in current assets such as inventories and current liabilities such as accrued rent or interest. Their usefulness is thus increased by connecting the flow of funds during the year to the stock of working capital on hand on the balance sheet dates. With respect to term debt coverage ratio, a ratio greater than one indicates that there is more net income being generated than is required for term debt repayment. The larger the ratio, the greater the ability of the farm to weather an income decline. A ratio less than one indicates potential problems for term debt repayment. Similar information is provided by the term debt repayment margin. Using this measure, positive values indicate sufficient income for repayment, and negative values indicate repayment difficulties.

4 Measuring & Analyzing Farm Financial Performance Worksheet 3. Repayment Capacity Ratios and Measures 1. Current Ratio Current assets (Item m) 1 Current liabilities (Item n) ( ) Current ratio (=) 2. Working Capital Current assets (Item m) Current liabilities (Item n) (-) Working capital (=) 3. Term Debt Coverage Ratio: Net farm income (Item z) Interest (Item x minus operating interest) (+) Depreciation (Item c) (+) Family living expense (Item v) (-) Income for debt servicing and capital replacement (=) Cash used for capital replacement (from your records) (-) Income for debt servicing (=) Scheduled principal and interest payments on term debt (from your records) ( ) Term debt coverage ratio (=) Term Debt Repayment Capacity and Margin Net farm income (Item z) Interest (Item x minus operating interest) (+) Depreciation (Item c) (+) Family living expense (Item v) (-) Income for debt servicing and capital replacement (=) Cash used for capital replacement (from your records) (-) Term debt repayment capacity (=) Scheduled principal and interest payments on term debt (from your records) (-) Term debt repayment margin (=) 5. How much additional debt could this term debt repayment margin service? Term debt repayment margin (above) Amortization factor from Table 4 ( ) Additional term debt the margin would service (=) 1 Items refer to Worksheet 1.

5 Purdue Extension Knowledge to Go Table 4. Amortization Factors for Equal Annual Total Payments Interest Rate Years 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16%

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