We were out to see Fast Freddy last week and boy was he on cloud nine! His banker, George Gimeital, had offered him this great deal. George offered to finance a new combine and swather and provided Freddy with a pre-approval for the purchases. Freddy was intrigued by the idea but wanted to look closer at the option. Freddy knew he already had significant payments to make every December and was not sure if this deal was as good as it sounded.
The bank had indicated they were comfortable with the level of debt payments on Freddy’s farm. They calculated his per acre payments to be $70 and rent in the area was around $50 per acre. What they were saying seemed to make sense to Freddy, but something didn’t sit quite right. Freddy knew his payments would be going up $15 per acre, and he didn’t feel as though he had had this kind of surplus in the past. Freddy was confident the bank understood his financial history, based on his income taxes, but in the last 18 months Freddy’s father had retired from farming and his oldest son was either working towards his degree or pissing away his inheritance — only time would tell!
We started by updating Freddy’s balance sheet and then did his annual projection for 2012. Two of of the important concepts we always calculate are fixed charge requirements and coverage. Fixed charge requirements (FCR) are made up of all of the fixed expenses:
FCR = principle payments + interest payments + lease payments + land rent + property taxes + living expenses or personal drawings
The ability to meet these expenses, the fixed charge capacity (FCC) is equal to:
FCC = accrued net farm income + depreciation + term interest + lease payments + land rent + property taxes
The fixed charge coverage (FCCov) is the ratio of the ability to meet charges to the fixed charges:
FCCov = FCC / FCR
These calculations are slightly different from debt service coverage:
Net farm income + off farm income – living expenses and income tax + depreciation + term interest payments / term debt payments
When we completed our analysis of Freddy’s operation, the following figures showed up in his report:
- Gross revenue: $367/ac.
- Fixed charge requirements: $125/ac.
- Fixed charge capacity: $128/ac.
- Fixed charge coverage ($128/$125): 1.024
- Debt service coverage: 2.72
- Residual after D/S: $142,000
Freddy’s gross revenue per acre, $367, is in line with area averages. His fixed charges ($125 per acre) are above the area average, indicating that his operation requires more net income than neighbouring and competing operations.
The difference between a comfortable debt service coverage ratio and a tight fixed charge coverage ratio can often result from not clearly understanding living expenses and personal drawing requirements on a farm.
With Freddy’s father retiring, he will begin to draw a salary from Freddy’s farm. Freddy’s son, Steady Teddy, is also consuming an additional $20,000 per year. These calculations quickly confirmed Freddy’s concern that making more payments may not be as comfortable as he first thought. Freddy’s debt service coverage was very comfortable, however his fixed charge coverage was marginal at best.
Understanding the difference between debt service coverage and fixed charge coverage is crucial for a manager to truly understand risk. Freddy’s strong working capital helps to mitigate the risk of high fixed charges. The last thing his business needs is more payments that will further increase those fixed charges. †