Farm debt and interest rates: What’s the connection?
Gearing up for another year? FCC Ag Economics wants to pump up your farm financial fitness. Throughout March, we'll be sharing posts to help put your 2017 farm financials into a larger context. We'll also makes sense of key financial tools as you go. Check back weekly to see where Canadian ag is going and how you can stay ahead.
Income is the primary source of repayment for loans. In this post, I’ll look at interest rates and the risks they pose for the capability to meet financial obligations. I’ll will explore how to focus on efficiency to control costs, boost income and protect the ability to repay debt.
Debt service ratio? What does it mean for you and Canadian ag?
In 2016, AAFC estimated the average Canadian farm had $77,923 in income after expenses. Total liabilities per farm averaged $609,843. According to AAFC’s 2017 Canadian agricultural outlook, the average farm’s net cash income (NCI) is projected to decline to $73,486 in 201. Crop receipts are expected to rise on the strength of global demand and the strength of the 2016 harvest, but these won’t be enough to offset the projected declines in both cattle and hog receipts. The ongoing expansion of both herds in the U.S. will continue to pressure prices. Neither will Canadian NCI be able to grow in 2017 as it did in 2014-15, when the Canadian dollar depreciated relative to the USD. No further depreciation is expected and the CAD should remain stable at around US$0.75 throughout 2017.
At the same time as net cash income is forecast to decline, total liabilities are expected to increase. The average Canadian farm’s total liabilities should increase to $647,771 in 2017. Declining income and increasing liabilities could pressure the debt repayment capacity of overall Canadian agriculture.
The primary source of debt repayment is income – and those farms most likely to increase their liabilities are in the crop sector, where receipts are likely to continue growing. And whatever decline we’re about to see has to be put into perspective: 2016 should prove to be Canada’s second-best-ever year for NCI and 2017 is expected to be the fourth-best on record.
Debt service ratio
The debt service ratio measures the cash available for debt servicing (i.e., interest, principal and lease payments). It’s calculated by dividing net operating income (or earnings before interest, depreciation and amortization) by an operation’s annual debt service payments. A higher debt service ratio indicates a farm is better positioned to meet debt and interest expenses.
How it works
A debt service ratio higher than 1.25 would suggest an operation faces low to medium credit risk. This ratio would occur when a farm has $125,000 in net operating income and with a maximum of $100,000 in annual debt payments (debt service). It is important to note that other variables will be considered to assess the entire risk picture of an operation. There is no single variable that provides a full assessment of the financial situation of an operation.
When a farm’s ratio falls below 1.25, repayment becomes more challenging, and a ratio below 1 means the farm isn’t generating enough income to make payments. If income of a sector is generally more volatile, a higher ratio will be considered low to medium risk. Similarly, more stable sectors of agriculture can bear a lower ratio.
Here’s an example with Canada’s average 2016 farm data (assuming an interest rate of 3% and a loan life of 15 years):
- Net operating income = $77,923
- Annual average debt service payment = $50,538
- The debt service ratio = $77,923 / $50,538
All things considered, the debt service ratio indicates no issue for the average Canadian farm to meet its debt obligations in 2017. Recalculating the debt service ratio with AAFC’s 2017 projections, the ratio for the average operation becomes:
- Net operating income = $73,486
- Annual average debt service payment = $53,681 (total liabilities of $647,771)
- The debt service ratio = $73,486 / $53,681
The “average” debt service ratio will likely decline in 2017, but still be above a reasonable threshold. The above ratios account for all farms – even those that carry no debt. Actual debt service ratios of Canadian farms will vary depending on the producer and by enterprise type.
What if interest rates also increased?
While we don’t expect the Bank of Canada (BoC) to increase interest rates in 2017, we do project borrowing costs will rise as fixed rates will face upward pressure from the bond market.
Let’s assume interest rates increase 100 basis points for an interest rate of 4%. This means the annual payments on total liabilities increases to $57,498. As a result, the 2016 average debt service ratio changes even further to 1.3, calculated as $73,486 / $57,498 = 1.3.
Here’s a good farm management practice: run scenarios using lower and higher interest rates to determine your ability to meet debt obligations.
With current income levels expected to drop marginally, the Canadian agriculture debt service ratio should remain well above 1.0. Only if income falls a lot as interest rates increase, would it fall below 1.0 (i.e., a 200 basis point increase coupled with a 20% decline in net operating income). In this scenario, the farm might be forced to renegotiate their debt service load or look to farm assets for breathing room.
Efficiency key to supporting income
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 productivity and income, and ultimately be ready to face unfavourable movements in rates or commodity prices.
Lower costs through operational efficiencies. One way to assess how an operation stacks up against others in terms of the expenses used to generate revenue, is to use the operating expense ratio.
Using the 5% Rule
The “golden rule” of farm management: a 5% improvement in productivity (e.g., yield gains on a canola farm), plus a 5% increase in the price obtained (from marketing savviness), plus a 5% gain in efficiency (lowered production costs) equals… up to a 117% gain to the bottom line! The key is that each of the 5% improvement helps magnify other improvements and snowballs to a big amount.
Operating expense ratio
The operating expense ratio measures the percentage of operating farm expenses (e.g. variable expenses such as seeds, feed or labour) for every dollar of farm revenue. The ratio represents the amount of money left after covering the farm operating expenses to service debt and additional investments into the farm business.
How it works
A lower ratio means an operation uses fewer variable resources to earn a dollar of revenue. A technically efficient farm optimizes the opportunities for generating income. Typical average operating expense ratios should not exceed 65% but will vary by agriculture sector, and even within a sector. For example, we reported in 2016 that Canadian dairy producers in the top 20th percentile have operating expense ratios of 0.55, while at the 50th percentile, the operating expense ratio was 0.65.
Calculate your operating expense ratio using the following formula: The operating expense ratio = Operating Expenses (excluding interest and depreciation) / Total Revenue