Staying financially strong when interest rates rise
As interest rates slowly rise from their historic lows, we want to help pump up your farm financial fitness. Throughout March, we'll be sharing posts to help put your 2018 farm financials into the larger Canadian context and explain key financial tools as you go. Check back weekly to see where Canadian ag is going and how you can stay ahead.
Projections of flat farm income combined with an expected rise in interest rates increase the likelihood that farm operations will face financial pressure in 2018. But I think there are enough positive opportunities for Canadian producers to overcome any potential challenges the year ahead may bring.
Canadian agriculture remains financially strong
The financial health of the ag industry in Canada can only be assessed using multiple financial ratios. One of the most important ratios is the debt-to-asset ratio, calculated by dividing total liabilities of the farm sector by farm asset values. The Canadian agricultural debt-to-asset ratio was 0.154 in 2016. That means Canadian producers were financing $0.15 of every dollar of assets with debt.
Overall debt grew 43.8% over the last five years, and it increased 7.5% in 2016. With asset values growing 5.04% on average nationally in 2016 (and 36.5% over the last five years), asset values have generally outpaced debt levels.
2016 was the first year we saw an increase in the ratio after declining each year since 2009. 2017 and 2018 are projected to see further increases in the debt-to-asset ratio for Canadian agriculture. Yet the projected debt-to-asset ratio is indicative of a healthy sector.
(Source: Statistics Canada, FCC calculations)
The financial picture at the farm level can be different than at the industry level. Operations that are going through an expansion phase will have a much higher degree of leverage than the industry ratio suggests. Why is this important? A low debt-to-asset ratio brings flexibility in that a business can borrow more if an investment opportunity arises. How do you assess the ability of a farm to carry more debt, especially in a higher interest rate environment?
Rising interest rates can hamper financial strength- but to what extent?
Debt repayment obligations may rise if 2018 income is stable and interest rates increase as expected. Operations that carry debt on their lines of credit or variable-rate loans in general will see their interest expenses rise. One way to look at the sensitivity of an operation’s tolerance for interest rate increases is the Debt-Service Coverage Ratio (DSCR = debt service capacity/debt service requirements). This ratio is calculated by dividing net operating income (or earnings before interest, depreciation, and amortization) by an operation’s annual debt service payments. It measures the cash available to pay off debt obligations in that same period.
Let’s consider an example: an operation has net operating income of $75,000 and a loan amount of $500,000 amortized over a ten-year period. When evaluated at a 3% interest rate, the DSCR is 1.29 (see the table below). A 2.0% increase in the interest rate lowers the DSCR to 1.18, indicating a greater drain on net income.
Interest rates are not the only source of risk to consider. A decline in revenues available to service debt will impact a producer’s financial strength. A 10% decrease in net operating income coupled with a 2% increase in the interest rate would decrease the DCSR to 1.06 – indicating a tight repayment capacity.
A DSCR lower than 1 means insufficient funds to meet debt obligations. Conversely, a DSCR higher than 1.25 leaves room to meet unexpected changes in the financial or economic environment.
Producers can’t control where interest rates may go. That’s why it’s important to focus on management decisions such as using the 5 per cent rule to control costs, raise revenues and productivity, and ultimately be ready to face unfavourable movements in rates or income.
Are you comfortable using financial statements to better manage your operation? A good place to start is your accountant or an FCC Relationship Manager.
Amy joined the FCC Ag Economics team in 2017 to monitor agricultural trends and identify opportunities and challenges in the sector. Amy grew up on a mixed farm in Saskatchewan and continues to support the family operation. She holds a Master in Applied Economics and Management from Cornell University and a Bachelor in Agricultural Economics from the University of Saskatchewan.
In this series
As farm profit margins tighten financial resilience will be important. What can we learn from the downturn in the U.S. farm sector?
As 2018 interest rates are expected to increase, are fixed or variable rate loans your best option?