Strategic Business Planning for Commercial Producers Debt Service Analysis: Can I Repay?
Mar 31, 2015
Strategic Business Planning for Commercial Producers
Debt Service Analysis: Can I Repay?
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
How Much Debt Can I Repay?
• Depends on– Repayment capacity– Interest rate– Repayment period for
borrowed money
Strategic Business Planning for Commercial Producers
How to Measure?
• Term Debt Coverage Ratio• Term Debt Repayment Margin
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
Worksheet 3. MBC FarmsTerm 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.
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
How Far Can I Stretch Margin Dollars For New Capital Purchases?
MBC Farms1. 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
Strategic Business Planning for Commercial Producers
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?
Strategic Business Planning for Commercial Producers
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%
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
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?
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
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?
Strategic Business Planning for Commercial Producers
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?
Strategic Business Planning for Commercial Producers
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?
Strategic Business Planning for Commercial Producers
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
Strategic Business Planning for Commercial Producers
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 $