Managing your operation’s debt service capacity is part of an overall risk management strategy
by Jackie Clark
As producers look to maintain or expand their operations, they must be mindful of their debt servicing capacity, Carl Fletcher told Better Farming.
He is a retired farm business management specialist at the Ontario Ministry of Agriculture, Food and Rural Affairs and a member of the Canadian Association of Farm Advisors. Fletcher is based in St. Thomas.
Debt servicing capacity is “the amount of money your farm does or can afford to spend on principal and interest in a year without compromising the farm’s ability to cover operating expenses, depreciation, and living income and profit return for the owners,” Fletcher explained.
In an industry that requires high-cost capital expenditures, farmers can use debt to grow their businesses. “But, once it is acquired, debt adds a fixed cost to the cash flow. Loan payments are made up of principal and interest” amounts, Fletcher said. It’s important for producers to “manage the risks of (loan) cost increasing beyond affordability.”
To start, you can work with your lender, accountant or adviser to determine “the maximum amount of total principal and interest both you and your farm business are willing or able to pay annually. … The interest may be fixed or floating.
“Having seen what happened with the high interest rate of the early 1980s, many people in my generation, myself included, are and have been apprehensive about the cheap interest rates that have made borrowing relatively cheap compared to the 100-year perspective,” Fletcher explained.
However, “many farmers have successfully used the low interest rates of the past decade to their advantage,” he added.
Producers can evaluate what they think the probability of a rise in interest rates is, and what effect that increase would have on their businesses, to determine how risky a certain amount of debt is to their operations.
Once you have “set a maximum total loan payment limit for your operation, calculate how those payments could change with higher interest rates,” Fletcher said. These calculations would enable “you to set an ‘early warning target’ interest rate on floating-rate loans that you do not want to go past. (This target) would (serve as) a prompt to you to lock in an interest rate at that time if rates rise.”
Generally, principal rates on loans are fixed.
“Options that allow paying off part of the principal early at no penalty can help create some flexibility and build equity. Refinancing a loan can carry a penalty cost but spreading the balance of the loan over a longer period can reduce the debt loan payment costs for the farm on an annual basis,” Fletcher explained.
“Refinancing usually requires equity to secure the loan. Monitoring and maintaining the ‘spare’ equity in your operation can be a safeguard in case of a refinancing threat.”
Producers should be mindful of the dates on which their loan payments end. Farmers can use this information to help plan for new investments in land, equipment, or other large purchases that may require additional loans.
“Life and business are balancing acts,” Fletcher said. “If a new loan supports a new investment that truly increases profits over and above the loan payments, then increasing the total amounts of farm loans and loan payments can be the right thing to do.”
Producers should keep good records and work with their advisory teams to help make these important decisions. BF