The first two columns in this three-part series focused on using the operating statement to monitor operating efficiency and to diagnose operating problems. In this column, we turn to the interaction between the balance sheet and operating statement to identify and manage financial risk.
This is very topical currently because of concerns that lower grain prices will lead to lower land prices, potentially putting those who bought high-priced land in financial difficulty.
Traditionally people used the Debt/Equity ratio as a measure of financial risk. If this ratio is equal to 1.0, it means your debt is equal to your equity. The higher the ratio, the higher your “leverage” and the higher your risk of losing the farm if you can’t pay down debt. The problem is that what it is telling you is whether you have enough assets to cover your debts if you fail. Lenders like it because they want to know their loans are secure if they have to sell your assets. That’s a little late for useful management information!
- More ‘Finance metrics you may not have thought of’ with Larry Martin and Heather Brown: Operating efficiency and Diagnosing operating inefficiency
More useful for management is Debt/EBITDA, i.e. debt to operating earnings. If your Debt/EBITDA is 5.0, and if you use all your operating earnings to pay principal on your debt, it will take five years to pay it off. During that time you will not use any of your annual operating earnings to pay interest, make new investment, pay taxes or pay yourself.
The higher the ratio, the higher the financial risk, because your operations are linked to your debt. Start with the proposition that if you buy an asset such as a farm or a major piece of equipment, there are only three possible ways to pay for it, i.e. 1. From the earnings it generates for the farm; or 2. You either sell it or have it eat into the farm’s equity; or 3. Your rich uncle dies and leaves you a nice inheritance! There are no other choices. Most people don’t have the third and don’t like the second: forced sales are not fun.
Using Debt/EBITDA can help mitigate getting into financial difficulty, starting with understanding benchmarks. For non-farm businesses, most lenders like to keep this ratio under 3.5:1. Agricultural lenders usually go higher: Canadian tax-filer data puts the average for Canadian farms at 5:1. Our experience is that 6:1 is a useful limit for farms that are expanding.
This is where understanding the interaction between the balance sheet and operations becomes useful. Our earlier columns pointed out that successful farms aim for operating efficiency of 35 per cent or more. If a farm has 22 per cent operating efficiency and Debt/EBITDA of 8:1, it is going to be very difficult for it to pay off its debt. There is almost no chance it could make any major new investment.
The ratios tell us that two things need focus here. One is to reduce debt as quickly as possible and, certainly, not take on more debt. The other is to improve operating efficiency from 22 per cent so debt can be paid down more quickly.
The reason lenders go further in agriculture is that farms often have “off-balance sheet” equity because they are carrying land and/or quota at cost instead of market price. Therefore, they pay attention to the Debt/Equity ratio because it gives them a good picture of their security. However, managers need to worry about avoiding financial difficulty. Equity can only pay down debt if it is turned into cash!
Another useful feature of this ratio is that it can help guide growth plans. Some of the most successful operations with whom we are familiar have Debt/EBITDA around 2.5 to 3.0 on average over time. However, it may jump up to 5 or 6:1 when a new major investment is made such as a farm expansion. But it goes down to less than 2.5:1 as that debt is paid off before the next investment is made.
Well-managed farms that are growing manage their growth by ensuring that each major expansion is on the way to being paid for before the next one is made. If the ratio gets much above 6:1, then the farm is facing tremendous risk of a series of low-price years, a major policy change, and/or a series of production problems that reduces yield or price.
On a final note, in calculating the ratio we use an average of three years of EBITDA to take out market fluctuations and we tend to use bank debt instead of total liabilities for the calculation. Usually, bank debt is the most important because banks usually have first mortgages and care mainly about repayment of their debt. In this case, bank debt is the financial risk.
Larry Martin is co-owner and lead instructor in AME’s management training courses. Heather Broughton is co-owner and president of AME.