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Calculating Debt Coverage

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.

This is part four in a four part series.

For this last article, we focus on coverage within the business. Analysis of coverage indicates one key message — What is the ability of the farm business to repay its fixed obligations?

There are a number of ratios we can use to measure efficiency.

1) Gross Revenue per production unit = Total accrued revenue over number of production units

This figure indicates the gross revenue achieved from each productive unit such as a cultivated acre, number of animals, units of quota etc.

2) Fixed charge capacity per production unit = (Gross revenue per unit) x (1-Operating expense ratio)

This figure indicates the amount remaining after operating expenses that can be applied to fixed charges (debt payments + lease payments + property taxes + living/withdrawals). As a business considers growth, assuming no change in efficiency, this figure can indicate the business’s ability to fund the capital investment portion of the growth that is financed.

3) Fixed Charge Requirements per production unit –(debt payments + Lease payments + Property Taxes + Living/withdrawals) divided by Production units

This figure indicates the present level of fixed charges per unit. Comparing the present capacity of the business and the requirements can quickly indicate the business’s ability to meet its obligations and use this measure to evaluate the risk of taking on additional debt or drawings such as in a succession plan.

4) Fixed charge coverage = Fixed charge capacity over Fixed charge requirements

This ratio indicates how many dollars are available for every dollar required in fixed charges. A comfortable ratio here will vary among enterprises, regions and risk tolerance of management.

5) Debt service coverage = Accrued net income + interest + depreciation –living/withdrawals over Required Principal + Interest Payments

This ratio indicates how many dollars are available for every required dollar in debt payments. A comfortable ratio here will vary among enterprises, regions and risk tolerance of management.

6) Residual after debt service = (Accrued net income + Interest + Depreciation –Living/withdrawals) minus Required debt payments

This figure indicates the amount of flash money that Johnny Cash will have in his jeans after the banker is taken care of.

7) Residual for growth = Residual after debt service + principal payments –depreciation expense

This figure will be negative if the operation has a depreciation expense greater than the principal repayment which could indicate the risk that the business is living off of depreciation.

So what do these numbers mean and why do I care? You need to care because these ratios and figures indicate:

How much risk am I taking on at the present time?

What is my ability to make my payment commitments this fiscal year?

Am I living off of the depreciation or am I positioned for growth?

What is the ability of my business to finance a portion of anticipated growth and how much of that growth would be responsibly financed?

Is there room for the next generation in the existing business?

The focus of coverage ratios is to determine what fixed charges are for the operation and the likelihood of the business to cover those. This is another measure of risk and should be considered prior to strategic planning such as succession or growth opportunities.

Some mitigating factors for having poor coverage ratios can be:

Strong liquidity can provide an immediate cushion for covering fixed charge demands in a poor year without jeopardizing cash flow going forward

High Equity can provide management with the opportunity to refinance at some point and reduce the level of fixed charges which may not be an option for a highly leveraged business.

Strong cash flow management skills can allow management to foresee payment difficulties before they arise and thus make suitable arrangements.

Debt Service Relief or loans that will soon be repaid will decrease fixed charge payments and thus increase the coverage ratios.

Finally, marrying the right spouse or more precisely marrying money can go a long way towards eliminating concerns over making payments.

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 and 204-825-8443

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