Generating more profit from your farm business

Finance costs

Is debt assisting or constraining profit growth?

Debt can only assist a business if the business can generate a higher profit, net of finance costs, than it could without the debt. Ideally, the business should be able to repay debt in 10-15 years.

Interest coverage ratio is a useful ratio to determine how easily a business can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expenses of the same period:

Interest coverage ratio = EBIT / interest expense

A ratio under one means that the business is having problems generating enough cash flow to pay its interest expenses. In general terms, many farm business would want the ratio to be over three as this will most likely indicate the business is generating sufficient cash flow to pay interest, tax, make small debt repayments and fund personal expenses (drawings). Note that this assumes depreciation is reflective of machinery replacement costs over their useful life. Interest cover above four will often mean there may be cash flow available to upgrade or replace machinery and pay down debt faster.

Earnings volatility must also be considered in evaluation of the Interest Coverage Ratio. The higher the earnings volatility the higher the interest cover should be to ensure interest costs can be paid in the poor years. If the interest coverage ratio is above three it means that earnings (EBIT) can fall by two-thirds and interest can still be met assuming interest rates do not change. However, there would be no cash flow available to meet debt repayments, personal expenses or machinery upgrades.

Equity is the percentage of owned assets. It is calculated as total assets less total liabilities divided by total assets. The table below compares how variations in equity percentage can impact profit for a 2000ha farm business that has a total asset base of $7m and, on average, generates $250/ha in EBIT. This table shows that at 60% equity this farm would take approximately 21 years to repay the debt from after tax and drawings earnings. By comparison lifting equity to 70% increases net profit after tax and drawings (NPATD) by 23% and debt would be repaid within 13 years under the same interest and earnings assumptions.

The more debt laden the business, or lower the equity percentage, the more sensitive the profit is to changes in interest rates. The results in Table 2 highlight the sensitivity of profit to small changes in interest rates. The example in Table 2 shows that if equity is 60% an increase in interest rates from 6% to 7% results in profit after tax and drawings (NPATD) declining by 15%. If this same business had 80% equity the NPATD impact of the same rise in interest rates would be 5%.

The table also highlights how rapidly the repayment period escalates as interest rates increase for a business with lower equity. For instance, if the business had 60% equity and interest rates rose from 6% to 7%, the time it would take to repay the debt would increase from 21 years to 25 years. By comparison, the business at 80% equity would take eight years to repay its debt compared to seven years at the lower interest rate of 6%.

Earnings are also highly volatile in farming businesses largely due to price and seasonal volatility. Table 3 shows the impact a decline in EBIT from $250/ha to $200/ha has on NPATD and debt serviceability. It shows that a business with 60% equity would experience a 53% decline in NPATD to $31/ha which restricts funds available to pay back the debt so the payback period more than doubles to 45 years if EBIT continued at this lower level. By comparison, if the business had 80% equity the $50/ha contraction in EBIT sees NPATD fall by 36% and the payback period stretches to 12 years from seven years.

These results also display the importance of maintaining high equity percentages and/or high and consistent EBIT to grow a farm business.

Working capital costs and cash flow management also need to be considered with finance costs. Generally a working capital line of credit (overdraft) attracts higher interest rates than term debt. If a business is incurring higher interest charges for an overdraft consider increasing the term debt facility limit at lower interest rates with an offset account. This will allow the business manager to draw down funds during peak debt periods at lower interest rates and, once income is received, deposit it in the offset account so interest costs do not accrue.

Typically, mixed farm enterprises receive revenue three times a year, being the grain, wool and sheep meat revenue. As such, mixed farm enterprises have much lower working capital costs than cropping only enterprises which can wait 10-12 months for payment. This cash flow needs to be considered when comparing costs of different enterprise mixes. There are options available to assist smooth cash flow and reduce peak debt such as pre-payment, progressive payments and deferred payments. The costs associated with these need to be weighed up against any savings in finance costs. The implications on taxation also need to be considered.

Management strategies to reduce finance costs include:

• find out what terms other financiers may offer your business
• re-negotiate terms with existing financiers
• restructure the debt (for example, replace overdraft with cheaper term debt and add an off-set account)
• offer the lender more security in exchange for lower interest rates
• fix interest rates to mitigate risk of rising interest rates
• replace debt with equity
• sell land and lease land under certain terms and market conditions
• change payment terms for debtors and creditors
• repay debt.