In this article, we’ll talk about measure nine, Repayment Schedule: Scheduled Debt Repayments.
Almost all businesses manage debt. Scheduled annual debt payments as a percentage of gross farm receipts is a good measure of competitiveness. Some debt can allow a business to take advantage of opportunities that enhance profitability.
Too many scheduled principal, interest and capital lease payments seriously affect the ability of a business to meet cash obligations, have enough left to provide desired operator income and reinvest in the business.
Income available
If the operating expense ratio (Measure 3), which measures how much of the gross farm income is committed to paying operating expenses is 70%, and the scheduled debt payment is 10%, then 80% of the farm’s gross income is committed to paying operating expenses, principal, interest and capital lease payments.
This leaves no more than 20% of gross income available to pay taxes, provide operator income (sole proprietorships), operator retirement investment, increase farm cash reserves and provide dollars for reinvestment back into the business or investment off the farm.
Total scheduled principal and interest payments used in this calculation do not typically include accounts payable within the next 30 days. Other open accounts that are kept current even if the payment is due in more than 30 days, such as an annual land rent payment, would also not be included.
However, accounts payable must be considered if they are open and balances are building up because the business is unwilling or unable to pay them.
Paying balances
How will the farm pay these balances? One option is to commit to paying them over the next 12 months on a self-imposed payment plan. The other is to amortize the accounts payable into one or more longer-term notes with scheduled principal and interest payments.
If the farm must follow this strategy, it can allow the farm to pay a lower interest rate than is typically charged on open accounts.
However, this means the farm has incurred debt for operating expenses, not debt that helped the farm become more efficient or productive. The farm must carefully evaluate how and why it got into the position of accruing unpaid balances and determine how it should change the business to minimize the possibility of this happening again.
Factors affecting scheduled annual debt payment include total farm debt, how debt is structured (short, intermediate or long term), interest rates and gross farm receipts.
Managing payments
When scheduled debt payments are too high and cause difficulties in the farm business, a manager must first determine why they are too high and causing difficulty. Once the cause or causes are determined, then a farm manager must explore options and finally take action.
If the business has significant short-term debt, rescheduling some of that debt over a longer (but realistic) term will decrease annual payments. Review loan terms relative to the asset purchased. Loan terms should generally reflect the useful life of the item in the business.
For instance, if a milking parlor with a projected 15-year useful life is financed with a three-year note, cash flow will be severely compromised. If currently available interest rates are lower than those you are paying, refinancing is also an alternative worth investigating.
Reducing total debt through sale of unused assets or carefully planning, controlling and spreading debt over more cows are also options. However, any alternative will only be successful if the business is profitable.
Numbers
In some cases, when money is borrowed for an expansion, annual debt payments as a percentage of gross receipts decreases, even though total debt increases. Scheduled debt payments for the high 20% of farms (based on net return per cow) in the Ohio Dairy Farm Business Summary averaged $396 per cow and 5.5% of gross receipts for 2011 through 2015.
The high 10% of all herds in the New York Dairy Farm Business Summary averaged $388 per cow and 6% of gross receipts for the same time period. The New York numbers include the net reduction in operating debt.
Using the calculation method described earlier, use your numbers to evaluate how your farm compares to the competitive level, evaluate your situation, and, if necessary, implement a management strategy. Discuss management strategies best suited for your farm with your lender and/or extension educator.
