Talk about debt when analyzing financial performance
Debt is all around us. Consumer debt. Government debt. Many economists will comment that too much debt exists in those categories, depending on how they evaluate the debt and its associated historic trendlines. When it comes to farms, debt is typically needed to finance capital purchases for major equipment, land and quota. The cost of these assets is simply too great to purchase them with cash.
Analyzing a farm’s financial performance by including discussions about debt is important. It provides insight into the financial risk that a farm holds. There are two trendlines to include in the analysis that provide yet further insight into the financial risk associated with a farm – the past years, or historic, trendline and the future years trendline.
Historically, the analysis needs to examine how debt on the balance sheet has changed over, say, the past 5 years. Importantly, one needs to look at where debt ‘sits’ on the balance sheet. Short term, or current debt is a function of liquidity and impacts on cashflow. Long term debt provides insight into a farm’s overall or longer-term solvency.
The analysis should examine whether debt (either current, long term or both) is increasing or decreasing. Further, the analysis should examine where the debt has originated. There is desirable and less-than-desirable debt. Debt associated with the purchase of productive assets such as land, livestock or quota would fall into the desirable category. Debt associated with non-productive asset purchases such as a cottage would be undesirable from a business perspective. Least desirable debt of all is debt associated with prior year losses.
The analysis distills the discussion around debt down to ‘numbers’. What the numbers mean for most farms, historically, are ‘black and white’ and lead to a very important question. How much debt is right for you? We gain insight into that question by looking at the future years trendlines on debt. Going forward, is debt going to increase, decrease or stay the same?
The table below presents a current and future situation and simple analysis that examines correlations between assets, liabilities, equity and profit.
|Category||Current Situation||Future Situation|
|Debt to Equity||50.0%||50.0%|
|Net Profit||$ 500,000||$1,500,000|
|Net Profit Ratio||16.7%||16.7%|
|Return on Equity||8.3%||8.3%|
The ‘current’ situation above presents a balance sheet that has $6 million of equity and $3 million of debt. Two dollars of equity for every dollar of debt or a debt-to-equity ratio of .5 – 1. This would be a comfortable financial position for a farm to be in, by many standards.
The ‘current’ situation income statement has a 16.7% operating profit ratio (net profit divided by revenue). Sustained over time, this too would be quite acceptable performance for the majority of farms. Return on equity is 8.3% (net profit divided by equity) and would compare favourably with earnings potential from other non-farm investment opportunities.
The future year trendlines commented on above are indicative of where a farm is tracking financially. All farms are tracking towards a financial future, based on their historic performance. The question becomes what a farm can, or should do, in striving to achieve the financial future it desires and/or needs in the future.
The ‘future’ situation in the table above applies a theoretical 3X multiplier to each balance sheet and income statement category. The performance analysis is constant. Similar financial efficiency at 16.7%. Similar profitability at 8.3% and similar financial risk at 50%.
Back to the question about ‘how much debt is right for you’. In the ‘future’ situation, total debt has increased to $9 million. That’s $6 million more than the amount in the ‘current’ situation. If that was your farm … currently and in the future … how would you feel about that?
If you were uncomfortable or stressed with $3 million, then likely you would be even less comfortable at $9 million. Even though the performance metrics are similar. What to do? No easy answers. If the family and business goals are to achieve growth in the business and importantly, if that growth requires capital investment, then logically the volume of debt is going to increase. How will it feel if, in a ‘future’ situation, you find yourself with a significantly larger volume of debt?
The volume of debt discussion can become interesting. At some point for a great many farmers, adding a zero or two to the amount of debt will become troublesome. I recall meeting with a farm family that had a relatively large operation with lots of equity but also, lots of debt. We ran the ‘numbers’ forward, applying the same constant performance analysis metrics through the next 5 years. The resulting ‘future’ situation had a theoretical increase of more than $12 million of additional debt. Even though the ratios were constant in the ‘future’ compared to where they were at in their ‘current’ situation, that volume of debt caused them to actively think about their plans for growth. Needless to say, not everyone in the family shared the same opinions.
Difficult discussions are often required, though, when debt feels burdensome. Worse, those discussions are typically avoided. It certainly helps to have a clear picture and understanding of the debt in your business. If necessary, find someone to help.
If you would like to speak to one of our consultants about this topic contact us.