Measuring Repayment Capacity and Farm Growth Potential

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by Michael Langemeier, Associate Director, Center for Commercial Agriculture

(Excerpt reprinted by permission of the author and Ag Banking Magazine. Find the full article here.)

Introduction

Repayment capacity measures include capital debt repayment capacity, capital debt repayment margin, replacement margin, term debt and capital lease coverage ratio, and replacement coverage ratio (Farm Financial Standards Council). Capital debt repayment capacity, capital debt repayment margin, and the term debt and capital lease coverage ratio address a farm’s ability to repay operating loans and to cover the current portion of principal and interest due on noncurrent loans such as a machinery, building, or land loan. The replacement margin and the replacement margin coverage ratio enable borrowers and lenders to evaluate whether a farm has sufficient funds to repay term debt and replace assets. For a farm to grow, it is essential that the replacement margin be large enough to repay term debt, replace assets, and purchase new assets, and that the replacement coverage ratio be greater than one. This article defines and illustrates the use of key repayment capacity measures.

Definitions

The capital debt repayment margin is computed by subtracting interest expense on term debt, principal on term debt and capital leases, and unpaid operating debt from prior periods from capital debt repayment capacity (accrual net farm income, off-farm income, interest expense on term debt, and depreciation minus family living expenses and income and self-employment taxes). The capital debt repayment margin enables borrowers and lenders to evaluate the ability of a farm to generate the necessary funds to repay the current portion of term or noncurrent debt. For this to happen, accrual net farm income, off-farm income, and depreciation have to be large enough to cover family living expenses, income and self- employment taxes, principal and interest on term debt, and unpaid operating debt from prior periods. It is important to note that the appropriate margin will vary among farms, and depends on the size of the farm and the type of enterprises produced.

The term debt and capital lease coverage ratio is closely related to the capital debt repayment margin. To compute this ratio, divide capital debt repayment capacity by principal and interest on term debt. A ratio greater than one indicates that the farm has enough funds to cover principal and interest on term debt.

The replacement margin and the replacement margin coverage ratio take the analysis one step further. The replacement margin is computed by subtracting cash used for capital replacement from the capital debt repayment margin. This measure enables a borrower to evaluate a farm’s ability to repay term debt and replace assets. It can also be used to evaluate a farm’s ability to acquire additional assets. Cash used for capital replacement can be measured using actual capital purchases (more specifically the portion of capital purchases that need to be paid for in the first year) or depreciation. The idea behind using depreciation is straightforward. Depreciation represents wear and tear, and obsolesce of machinery and buildings. Over the long-run, a farm needs to be able to replace machinery that is wearing out, to be able to afford new technology, and to be able to expand. We typically recommend using depreciation plus another 10 to 20 percent of depreciation as the farm’s measure of cash used for capital replacement to account for wear and tear on depreciable assets and farm growth. This amount will likely not be covered every year. However, over the long-run, it is essential that the replacement margin be positive. Without a positive replacement margin, a farm will not be able to fully replace depreciable assets or grow. Like the capital debt repayment margin, the replacement margin varies by farm size and type.

The replacement margin coverage ratio is closely related to the replacement margin. To compute this ratio, divide capital debt repayment capacity by the sum of principal and interest on term debt, unpaid operating debt in prior periods, and cash used for capital replacement. If the replacement margin coverage ratio is greater than one, the farm has sufficient funds to repay term debt and replace assets.

Find the full article at Ag Banking magazine’s Bank News website.

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