Debt service coverage ratio: Anchoring farm financial fitness
What a difference time makes. Borrowing costs climbed in 2018 from their historic lows one year earlier. Farm cash receipts flattened nationally over the same period. Throughout March, FCC Ag Economics will make sense of these evolving financials and more. Check back weekly to see where Canadian ag is going – and how key financial tools can help you stay ahead of the game.
For one thing, debt grew while farm cash receipts flattened for many sectors. Plus, as the overall level of farm debt grew, interest rates, and therefore borrowing costs, also increased. That pressured working capital. Rising input costs didn’t help. All of that not only squeezed profitability in 2018; it will also set the stage for 2019.
I use a key measure of Canadian agriculture’s financial health, the debt service coverage ratio (DSCR), to understand how producers have been able to cover debt payments in periods when income fluctuates, or interest rates rise. Both have occurred recently.
Debt service coverage ratio
The debt service coverage ratio measures an operation’s cash flow available to service debt.
DSCR = Income / Debt service
Income is defined as net cash income (farm revenues after taxes minus operating expenses before interest payments) plus other and off-farm income. “Debt service” includes all debt obligations in a year, including short-term debt and the current portion of long-term debt (loan principal due in the next twelve months or current portion of lease payments, for example) plus interest.
How it works
A DSCR of 1.5 indicates an operation has 1.5 times more cash available to pay current debt obligations than the total amount owing. A ratio below 1 indicates an inability to rely on net cash income and off-farm income to service debt.
If a DSCR is too low, a farm may find it hard to make payments on what is owed using only revenues. A very high DSC may not be optimal either. While it can reflect an operation that doesn’t need debt to generate revenue, it may also point to one that’s not exploiting market opportunities.
A note of caution
The DSCR can be calculated using different formulations of income and debt service. Compare different ratios only within each sector over time.
Understanding farm debt outstanding
Canadian farm debt has grown 6.5% on average each year between 2013 and 2017. It’s now over the C$100 billion mark. But neither fact worries me if farm income continues to gain enough to meet debt service payments, cover costs of production and, over time, grow equity. That’s still true even in periods when debt grows faster than income – which is what I think may happen in 2019.
To understand the magnitude of farm debt outstanding, we need to look at income, and how trends in income will be able to match trends in debt obligations. Canadian 2018 farm cash receipts are estimated to have totalled C$61.4 billion. They grew 11% between 2013 and 2017, helping net cash income grow 16% in that same period. That helped to keep the average DSCR for dairy, hogs, cattle, and grains and oilseeds farms* in a healthy range between 2013 and 2017 (Figure 1).
Figure 1: Rising net income maintains healthy average DSC ratios across sectors
Source: FCC portfolio data
Income strength overcomes volatility
Each sector maintained an average score between 2013 and 2017 well above the threshold for a strong DSCR. Dairy has had the lowest ratio each year, but the consistency in the sector’s capacity to meet debt service requirements reflects their unique income-debt structure. Grains and oilseeds producers had five years of strong revenue growth that pushed their DSCR to average 1.91 for the period. The cattle sector was also strong, although 2016’s plunging prices pulled both revenues and the DSCR below the 2011-2015 average of 1.87.
The hog sector’s fortunes improved in 2014 when the Porcine Epidemic Diarrhea virus (PEDv) cut U.S. supply and raised prices, then reverted to align more closely with the 2009-2013 average. The average DSCR showed strength throughout the period, but the volatility that characterized so much of 2018 will challenge it in both 2018 and 2019. Hog receipts are expected to have declined 11% in 2018, due to tariffs on U.S. pork exports to China and the resulting drop in North American prices.
I expect the hog sector to remain well-positioned to meet debt obligations in 2019 – even with a likely drop in the debt service coverage ratio.
What does the future hold?
Price volatility and higher borrowing costs can raise financial risk. 2018 saw both, a pattern likely to be repeated for several sectors in 2019. But while rising rates and swinging incomes can challenge the ability to meet debt obligations, Canadian ag is, overall, in a good spot to weather any downturn that may occur.
In particular, Canadian hog producers may find relief in 2019. Even if China and the U.S. fail to reach a trade deal that will eliminate retaliatory tariffs, the widespread African swine flu that triggered a liquidation of the Chinese herd may force buyers there to greatly increase their pork imports this year, a move that will almost certainly boost prices and support income.
As with each ratio we highlight throughout this series, the DSCR is only one view of the financial health of Canadian agriculture. Using different ratios together fills out the big picture. As well, using the average DSCR as we’ve done here doesn’t begin to tell the whole story, as it reflects both operations with recent production investments and lower DSCR scores, and more mature operations carrying lower debt levels (and higher DSCR scores). Work with your lender and accountant to determine the suggested ratios for your specific industry and be sure to understand them according to your own strategy and the risks facing your own operation.
* This analysis is based on data from FCC’s portfolio (2013 – 2017).
Are you comfortable using financial statements to better manage your operation? A good place to start is your accountant or an FCC Relationship Manager.
J.P. is the Vice-President and Chief Agricultural Economist at Farm Credit Canada. Prior to joining FCC in 2010, J.P. was a professor of agricultural economics at North Carolina State University and Laval University. He also held the Canada Research Chair in Agri-Industries and International Trade at Laval. J.P. is Past-President of the Canadian Agricultural Economics Society. He obtained his PhD in economics from Iowa State University in 1999.