Debt Service Analysis: Can I Repay?

Objectives

• Measure term debt repayment capacity, margin, and coverage ratio on your farm

• Evaluate repayment margin with respect to:1) Risk2) Borrowing power3) How to structure debt financing

• Think about operational strategies for managing debt repayment capacity

How Much Debt Can I Repay?

• Depends on

–Repayment capacity– Interest rate–Repayment period for borrowed money

How to Measure?

• Term Debt Coverage Ratio• Term Debt Repayment Margin

Term Debt Repayment Capacity Measures the dollar amount of net income available for servicing term debt

Uses: Step 1 in computing both the term debt

coverage ratio and term debt repayment margin

Estimate maximum safe farm debt load

Worksheet 3. MBC Farms

Term Debt Repayment Capacity MBC Farms

5. Net Farm Income (Item Z) $ 280,519

6. Interest (Item X minus operating interest) (+) 89,808

7. Depreciation (Item C) (+) 136,922

8. Family Living Expenses & Taxes (Item V) (–) 150,000

9. Income for debt + replacement (5+6+7-8) (=) 357,249

10. Cash used for capital replacement (–) 97,895

11. Term debt repayment capacity (9–10) (=) 259,354

Alphabetical items in parentheses refer to worksheet 1.

Worksheet 3. (Continued) MBC Farms

Term Debt Coverage Ratio

11. Term debt repayment capacity

$ 259,354

12. Principal and interest payments on term debt

$ 170,805*

13. Term debt coverage ratio (11/12)

(=) 1.52:1

*Principal paid = $80,997 + interest expense on term debts = $89,808

Term Debt Repayment Margin

Measures how much term debt repayment capacity remains after already existing term debt payments have been made

Used to: Evaluate the ability to acquire capital assets or

service additional term debt Decide how to structure additional financing Evaluate the margin of safety associated with

servicing term debt

Worksheet 3. continuedMBC Farms

Term Debt Repayment Margin20. Term Debt Repayment Capacity 21. Principal + interest on term debt

$ 259,354(–) 170,805

22. Term debt repayment margin (=) 88,549

How Far Can I Stretch Margin Dollars For New Capital Purchases?

MBC Farms

1. Term Debt Repayment Margin

$ 85,549

2. $ mount required to amortize $1 of term debt over 4 years at 7%

0.29523

3. Additional debt that could be paid (1 ÷ 2)

$ 289,771

Term Debt Repayment - Margin of Safety

How much can gross revenues fall before repayment capacity is lost?

Term Debt Repayment Margin serves as a buffer against risk.

How big should this buffer be?

Example of Margin of Safety Management – MBC Farms

Actual Forecast

1. Gross Farm Revenues$

1,796,651

2. Net Farm Income + Depreciation 417,441

3. Interest on Term Debts 89,808

4. Family Living Expenses 150,000

5. Cash used for capital replacement

97,895

6. Repayment Capacity (2 + 3 – 4 – 5)

259,354

7. Term debt principal and interest payments

170,805

8. Term Debt Repayment Margin (6 – 7)

85,549

9. Repayment Margin of Safety Ratio (8 ÷ 1)

4.9%

What is a safe margin? Critical Cash Flow Analysis

Critical cash flow is the minimum $ amount of gross income required to meet the farm’s needs to pay all of the following:

1. Cash operating expenses & interest on operating loan2. Scheduled principal & interest payments on term debt3. Withdrawals for family living expenses & income tax4. Cash needed for planned reinvestments in the farm

Managing The Term Debt Repayment Margin

• Repayment margin is more than adequate

How to use the excess? How to structure debt that will be serviced with the excess? How today’s decisions will affect this and future years?

• Repayment margin is not adequate

How to increase the repayment margin or reduce the risk of a shortfall?

Operational Strategies For Managing Repayment Capacity

• Repayment management has traditionally focused on minimizing debt relative to total assets, managing the terms and conditions of loans, and other financial strategies

• The amount of debt that can be managed safely can be increased by focusing attention on operational strategies for managing repayment capacity

• Operational strategies focus on making decisions and establishing policies that increase the likelihood that the necessary income will be available to make payments as they come due

How Would You Respond?First Scenario – The farm’s asset turnover ratio and operating

profit margin are exceptionally high; but, the farm’s term debt repayment capacity and margin are $98,000 and $(15,000) respectively. The farm’s term debt coverage ratio is .867:1. The farm’s solvency ratio (debt to assets) is 25%.

A. improve financial performanceB. expand operationC. alter debt repayment terms

How might you restore debt repayment capacity on this farm?

How Would You Respond?Second Scenario – The farm’s expected term debt repayment

margin is too small given the history of income variability on the farm. Tripling the forecast term debt repayment margin will still leave the farm highly exposed to the risk of a decline in net income sufficient to wipe out the expected repayment margin.

A. improve performanceB. expand operationC. alter financial structure

What operational strategies might a farm in this situation pursue to reduce the risk?

How Would You Finance This Investment?Third Scenario – The farm’s forecast term debt repayment

margin for this year is $190,000 and the farm’s margin of safety requirement is $135,000. On October 1 of this year the farm manager has $200,000 in cash on hand and is considering paying cash to make improvements to the farm’s grain handling and storage systems.

1) How much of the $200,000 is actually uncommitted and available to pay on the grain handling improvements?

2) What recommendations would you make about how to pay for the improvements to the grain handling system?

Summary • Debt is a valuable tool for fueling growth if managed

wisely• Repayment capacity is dependent on the ability to

generate net income• Repayment capacity is heavily influenced by repayment

terms, and the need for net income to support family living and capital investment

• Use operational strategies to enhance the management of repayment capacity.

• How much repayment margin is needed and what to do with excess margin are important questions for the farm general manager.

Strategic Business Planning for Commercial Producers

Loan Computations (see Table 4 in EC-712 for

the amortization factors) amount borrowed $

x amortization factor $

= loan payment amount $

or loan payment amount $

÷ amortization factor $

= amount borrowed $