Second Look: A financial lesson to be learned from the hog crisis

Monday, April 5, 2010

Two key ratios that give a clue as to why the Canadian hog
industry has been hit harder than its U.S. counterpart

by LARRY MARTIN

The George Morris Centre has an intensive management program called CTEAM for Canadian farmers, which has some people who teach aspects of managerial accounting. One aspect is a different way to measure financial risk on farms.

One of my colleagues and I are using this approach in a forthcoming study for a number of financial institutions. The study provides some interesting insights about the Canadian hog industry as it went into the past two plus years, which I'd like to share in this article.

In my experience, many people define leverage as debt/equity (D/E) or debt/assets.

Using D/E, a "highly leveraged" operation is usually defined as one that has a ratio well above 0.5, meaning twice as much equity as debt. Data on U.S. and Canadian farms show that the average D/E from 2001-2007 for hog farms with sales over $1 million in Canada and the United States was 0.4 and 0.3. The Canadian ratio was a little higher, but not out of hand and completely reasonable given that considerable new investment took place in Canada up to and during the early part of the decade.

So, why has Canada has been hit so much harder by the hog crisis than the United States, as evidenced by more closures and a much larger drop in hog inventory? To get at this from a financial perspective, two ratios need to be defined. They both use the accounting concept of earnings before interest, taxes, depreciation and amortization (EBITDA). This means operating profits after paying operating costs but before servicing debt and making new investment.

The first ratio is EBITDA to total revenue. It shows what portion of each dollar of sales is available for debt servicing, investment and profits. The second is Debt/EBITDA. It shows how many years are required for operating earnings to only pay off principal – without paying interest, taxes, replace any existing capital or keeping any profits for the owners. 

Obviously the two ratios are related.  If EBITDA/Revenue is 35 per cent, it means that, after paying operating costs, 35 cents of each dollar of sales is left to service debt and for new investment. That's clearly better than 15 per cent. Similarly, if Debt/EBITDA is 2.0, only two years of operating earnings are required to pay for principal, which is less risky than 5.0. In general, a high value of the first ratio and a low value of the second are less risky.

Figures I and 2 contain the ratios for Canadian and U.S. hog farms for 2001-2007.  EBITDA/Revenue was generally above 30 per cent for U.S. farms and at 10-15 per cent for Canadian farms.  Debt/EBITDA was 3-6 for Canadian hog farms and 1-1.5 for U.S. farms, and was at 6 for Canada in 2007. The lower operating ratio for Canada reflects all the problems we know about – lower hog prices, a rising Canadian dollar and likely relatively higher feed costs.

The debt ratio was particularly high entering 2008. So Canada entered 2008 with much riskier financial structures and Canadian farmers were hit much harder when the risks were manifested.

For me, when we come out of this period, the lesson is that these two measures of financial performance should become paramount. Canadian farms will need to focus on getting more earnings out of their assets and be more aware of the riskiness when debt is high relative to operating earnings. BP

Larry Martin is a senior fellow, the George Morris Centre and former chair, Department of Agricultural Economics and Business, University of Guelph.