Traditional Leverage Thresholds
Hogs (Stable Contract)
Hogs (No Contract)
Beef Low Risk
High Risk <50%
In January, the local banker Hans Immapocket asked many of our clients in the Grainews community for an updated net worth statement and income tax or financial statements in order to renew the operating line of credit for the next year. We do not want our clients to simply provide the bank with a number or ratio. Our focus is to work with the farm management team to build understanding about what this financial information means and how it can be used to make informed business decisions.
We help the manager develop a formal communication plan for all farm stakeholders and the financial institutions. This plan, like any good Clint Eastwood movie, summarizes The Good, The Bad, and The Ugly. The plan elaborates on any weak areas or risks, and also provides an opportunity to highlight strengths that mitigate these risks. This process provides a communication culture that is less prone to misunderstanding within the ownership team or with the financial institutions, both of which represent critical partners. It is often a natural tendency to avoid discussion around weak aspects of the business which compounds the risk. In reality, the management team should focus on these areas and gather input about how best to manage these areas of weakness.
This is Part 2 in a four-part series.
Today, we focus on financial structure — or leverage — within the business. The financial structure holds one key message: How are the assets owned by the business funded?
In other words, how much of the asset base within the business is owned by the owner, and how much of the asset base is financed. This relationship between owned and financed assets is expressed using three different ratios:
1. Leverage ratio is Total liabilities divided by (Total assets minus Total liabilities).
This ratio shows the amount of borrowed money compared to the amount of money the owner has invested. A leverage ratio of 0.75, for example, means that for every dollar that you have invested in your business, you have borrowed 75 cents.
2. Equity ratio is (Total assets minus Total liabilities) divided by Total assets.
This ratio indicates the percentage of assets that are funded by stakeholder investment or owner’s equity. For instance, an equity ratio of 0.60 would indicate that 60 per cent of the business is covered by shareholder investment.
3. Debt ratio is Total liabilities divided by Total assets.
This ratio indicates the percentage of assets that are financed. For instance, a debt ratio of 0.40 would indicate that 40 per cent of the assets in the business are funded with borrowed money.
So what do these numbers mean and why do I care? There are three reasons to look at these numbers:
To find out how much your business depends on creditors as financial partners.
To monitor financial progress or lack thereof.
To negotiate terms with financial institutions.
How much you depend on borrowed funds determines how much influence your financial partner will have in your business. If you are operating with a higher percentage of borrowed funds, that financial institution is a significant partner in your business and you had better take the time to understand their expectations and perception of your business. You cannot afford to have an inexperienced account manager make a mistake or misunderstanding. As such, your communication with that institution needs to be crystal clear and the relationship airtight.
Second, watching these ratios year over year will give you an
A leverage ratio under 70 is high risk for cereal and oilseed operations. Notice how that changes for enterprises — dairy, for example — with a stable income stream.
indication of growth. If appreciation in assets such as land is included, you have a clear picture of the changing equity position in the farm based on fair market value if the farm was to be sold. If appreciation in assets such as land is excluded, then you have clear picture of earned financial progress within the business.
Third, your understanding and your creditor’s understanding of these ratios are equally important so that when negotiations begin around interest rates and loan terms, you can negotiate based on the same assessment of leverage. For instance, if your farm is incorporated, and you own significant land personally but view that land as part of the farm, do you know how your lender accounts for that additional equity if you have signed a personal guarantee? If you have signed a personal guarantee, the risk for the lender is lower and should be reflected in the interest rate.
These ratios are excellent business indicators, but you must always remember that they are just indicators. Any one of them on its own does not always indicate a
problem. Ratios should always be used as a quick measure to determine if there is a need to look deeper. Managers can often use ratios to assess the level of risk his operation is taking. Also, before meeting with your banker, it helps to know your weak ratios and to have some mitigating factors that offset their weakness. Some common mitigating factors to a highly leveraged business include:
Income stability. For supply-managed industries, net income generated by the assets is higher and more stable allowing for an increased level of debt without increased level of risk.
Stable operating expense ratio within an enterprise. If your operating expense ratio has not fluctuated greatly, your net revenue stream is more stable and you will consistently have more capacity for repayment. This allows for a higher level of debt. If you see more variability in your operating expense level, you will require more equity or more liquidity in order to weather this.
Significant shareholder net worth. If shareholders have significant equity outside of the business that can be accessed or leveraged, this provides an opportunity for the owner to restore the business to a reasonable level of equity if problems arise.
Significant off-farm income does not bring risk into the business and thus allows the business to assume more debt on the same assets.
Lenders may mitigate the risk with more highly leveraged businesses by increasing their security position.
Andrew DeRuyck and Mark Sloane manage two farming operations in southern Manitoba and are partners in Right Choice Management Consulting. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning, and mediation services. They can be reached at [email protected]and [email protected]or 204-825-7392 or 204-825-8443.