One hundred thirty banks bit the dust during 2009, with more reportedly scheduled for the chopping block in the near future, reports Roy Ferguson, a financial consultant with the Ferguson Group in Tulsa, Okla.
"Most of the institutions that are not likely to survive are community banks, so the approaching impact on U.S. agriculture should not be too difficult to imagine,” Ferguson says. "Yet relatively few of the nation's commercial farmers and ranchers seem to grasp what looms ahead for ag financing.”
With potential credit limitations dead ahead, farmers who monitor their debt ratios will be in a better position to get the credit they need and avoid credit-related problems.
Time to Assess.
First, look at current liabilities as a percentage of after-tax profit (ATP), Ferguson urges. "This is a tiger that purrs contentedly when it is constrained within limits. When allowed to break loose, this ratio growls ominously before leaping to wreak havoc,” he says.
Sustained repayment of current liabilities is limited to just five sources, Ferguson says: (1) ATP, (2) positive cash flow, (3) income tax savings from depreciation, (4) additional equity capital and (5) incurring long-term debt. "Huge problems can arise from using any of these other than No. 1 for more than a brief period,” he says.
ATP levels more than 90% of the dollars generated for very long can shove ownership into a financial swamp as emergency cash reserves fail to grow, Ferguson cautions.
In today's environment, current liabilities at 90% of ATP are red flags: Lender comfort with a farmer's ability to repay are challenged.
Cash flow sufficient to satisfy debt repayment says nothing about depreciation or other income-tax factors, Ferguson adds. Overly aggressive use of accelerated depreciation often results in the depreciation being exhausted long before its useful life has expired, thus encouraging premature replacement and more debt, he argues.
"Adding long-term debt to cover pressing current liability payments only tosses additional fuel on an already blazing financial fire,” Ferguson says.
Measures of whether you are reaching the end of your safe borrowing capacity for term debt (five or more years) include the term debt coverage ratio, repayment capacity and repayment margins, says Purdue University economist Craig Dobbins.
The debt coverage ratio indicates the net income, not cash flow, from the farm business that is available for every dollar of principal and interest payment on term debt, Dobbins explains. "A ratio of greater than one indicates there is more net income being generated than required for term debt repayment,” he says. "The larger the ratio, the greater the ability of the farm to weather an income decline.”
"For term debt, I like to see at least 1.25 to allow a safety margin,” adds Danny Klinefelter, Texas A&M Extension economist.
Producers also should consider where they are in the farm business cycle, he says. "Right now, for example, margins are pretty tight. If you can achieve a 1.25 ratio now, when good times come again, you will be in very good shape.”
Top Producer, February 2010