Can you meet debt obligations? Use this financial ratio to evaluate
Throughout the month of October, we'll share key financial tools you can use to make sense of how your farm financials fit into the larger Canadian context. We’ll build on the insights of our report, Outlook for Farm Assets and Debt 2017-18, that provided a picture of the overall financial health of Canadian agriculture using Statistic Canada’s Balance Sheet of Agriculture. Using data from the 2015 Farm Financial Survey, our blog posts this month will instead focus on measures found on the income statement: liquidity, solvency and profitability. We describe Canadian agriculture’s status on each measure overall, and give you the ratios to use yourself, to better understand the health of your operation.
Following last week’s overview of the liquidity of position of Canadian farms, I examine in this blog post the capacity of Canadian farms to meet their debt obligations using the debt service ratio.
What is the debt service ratio?
The Debt Service Ratio (DSR) measures the ability to service debt (interest and principal) from net operating income (revenues minus operating expenses before interest). The higher the debt service ratio, the more likely a farm can meet its debt obligations.
Use this formula to calculate a farm’s DSR:
Debt service ratio = Net operating income / Annual average debt service payment
Net operating income is available from the FFS, but assumptions related to the length of repayment period and interest rates must be made to estimate the annual debt service payment. The results depict the ability of farms to meet debt obligations across sectors.
Debt service ratio of Canadian agricultural operations is high on average
The average DSR of Canadian farms was 2.0 in 2015. The average ratio is also markedly different across sectors. The greenhouse and grain and oilseeds sectors recorded the highest average of the 2015 FFS with ratios of 2.7 and 2.5, respectively. Dairy had the lowest DSR at 1.2. It is not unusual to find lower ratios in sectors that have usually stable cash flows. The DSR in the dairy sector has also likely improved since 2015, given the growing demand for butterfat and strategies to market excess production of skim milk.
Nearly 70% of farms in the greenhouse vegetable, field vegetable, potatoes, grain and oilseed sectors have a DSR greater than 2.5, mostly the result of strong farm cash receipts and low interest rates over the last several years. But some farms also recorded a ratio lower than 1.1, perhaps because of significant investments that require borrowing.
Distribution of the debt service ratio by sector, 2015
Rising interest rates – What does it mean for you and debt service?
Higher interest rates will raise the annual debt service payment of a farm over time. Starting from an average position, the debt service ratio is estimated to decline by 0.1 for every 25 basis point increase in borrowing costs. Of course, the impact will vary across sectors and conditional on the level of debt being carried.
Whether looking to leverage investment opportunities or simply monitoring the environment, it is always useful to run various scenarios around interest rates and net income to understand the financial position of your operation.
Leigh joined FCC in 2015 as a Senior Agricultural Economist, specializing in monitoring and analyzing FCC’s portfolio, industry health, and providing industry risk analysis. Prior to FCC, he worked in the policy branch of the Saskatchewan Ministry of Agriculture. He holds a Master of Agricultural Economics degree from the University of Saskatchewan.