Profit margins are expected to be tight this year, perhaps slowing debt repayment beyond the required minimums. In fact, despite low interest rates, some producers may be courting financial disaster by allowing debt—and capital investment—get too high relative to the income generated, cautions Roy Ferguson of the Ferguson Group, a consulting firm.
“Soundly structured farms and ranches that are reasonably efficient should be able to support interest expense equal to 15% of total revenue and still earn 8% to 10% gross profit on cash revenue consistently,” he says, based on studies of actual farms in the early 1980s, when many farms faced financial problems.
“At that time, it was believed that no alarm should arise until interest expense exceeded 25% of total revenue,” he says. That proved too high. “A USDA survey of several thousand operations that failed during the 1980sdiscovered that the interest expense on each was above 22% of revenue, confirming that the danger zone was lower. Today, most financial analysts say interest should not exceed 15%.”
There are operations with “astronomically excessive” interest-to-total revenue indices of 30% to 65%, he says. “Even if all their creditors were to agree to magically slash their existing rates by one-third, their ratios would still remain in the 22% to 43% range. When interest expense reaches 35% of any firm’s total revenue, waiving all interest charges forever would not delay bankruptcy even three days—because current liabilities would require principal payments far beyond the cash-flow capability.”
What to do if your ratio has crept up? Set a specific goal to work toward. Look for ways to boost revenue with the assets you already have. Consult a financial adviser about ways to restructure capital debt.