Does your business generate enough income to make scheduled debt and lease payments? If necessary, could that income also cover payments on additional debt? In today’s post, we’ll look at a set of financial measures that can help you answer these important questions.
Understanding Your Repayment Capacity
Two weeks ago, I discussed why it is important to monitor solvency, along with some measures you can use to do so. Today I’ll discuss measures of repayment capacity, which focus on two things. First, repayment capacity measures your ability to make scheduled debt payments on time using income from your business. If your business doesn’t generate enough income to make these payments, you’ll have to make up the difference with funds from other sources. If your repayment capacity is insufficient to make scheduled payments for long enough, you run the risk of eroding your business’s equity to the point of insolvency.
Repayment capacity also measures your ability to purchase or finance new capital assets for the business. Over time, assets like machinery, vehicles, and livestock must be replaced. If you’re not able to finance these investments when they are needed, your business’ profitability may suffer. The measures of repayment capacity that I’ll discuss here will tell you if you can finance those purchases when they are necessary.
Where to Find the Information You Need
The information you need to measure repayment capacity comes from multiple sources. First, you will need your business’ current balance sheet and income statement. These documents will provide information on the business’ income and on the business’ current debt situation.
In addition to these two financial statements, you will need information on your family’s living expenses and income tax liability. The tax information will come from your tax records. Information on family living expenses comes from your personal banking records or, if you have one, your family’s budget.
How to Measure Repayment Capacity
The Farm Financial Standards Council suggests tracking five measures related to repayment capacity. I’ll cover three of these measures here, starting with Capital Debt Repayment Capacity.
Your farm’s Capital Debt Repayment Capacity measures how much cash is available to make scheduled debt payments and to make purchases to replace capital assets. You can use the following formula to calculate this measure:
Net Farm Income
+ Depreciation
+ Net Non-Farm Income
− Family Living Expenses & Income Taxes
+ Interest Expenses on Term Loans
Capital Debt Repayment Capacity is the starting point for all other repayment capacity measures.
The next repayment capacity measure is your Capital Debt Repayment Margin. This measure tells you how much money is left over after all scheduled debt payments are made. What’s left over is what’s available to purchase or finance new capital assets, should they be necessary. Calculate Capital Debt Repayment Margin as:
Capital Debt Repayment Capacity
− Scheduled principle & interest payments on term debt
Finally, the Term Debt Coverage Ratio measures your repayment capacity relative to the size of your scheduled debt payments. Calculate this measure as:
Capital Debt Repayment Capacity
÷ Scheduled principle & interest payments on term debt
A Term Debt Coverage Ratio of exactly 1.00 indicates that your business income is equal to the size of your scheduled debt payments. You can make all scheduled payments, but you have no margin with which to purchase or finance new capital assets. If your Term Debt Coverage Ratio is less than 1.00 then your business’ income is not sufficient to cover all scheduled debt payments. In general, it’s a good idea to aim for a ratio greater than 1.75. A ratio value less than 1.25 indicates that your business may soon find making scheduled debt payments difficult.
Repayment Capacity and Debt Management
Keeping track of repayment capacity can help you manage your borrowing decisions so that you don’t put the solvency of your business at risk. Whenever possible, seek to maintain a healthy Capital Debt Repayment Margin and Term Debt Coverage Ratio. If borrowing to finance a capital asset purchase weakens these measures too much, consider altering the loan terms, financing the purchase through other means, or even holding off on the purchase until your financial condition is improved.
Keep track of Capital Debt Repayment Capacity to identify potential profitability, tax liability, or personal spending issues before they impact your ability to make scheduled debt payments. If any of these factors begin to erode your repayment capacity, consider ways to address the problem before they impact your business’ financial position.
How to Improve Your Repayment Capacity
Repayment capacity issues are normally caused by problems elsewhere in your business or personal finances. For example, your Capital Debt Repayment Capacity value might decrease for one of three reasons:
- The business is less profitable
- A source of non-farm income decreases or disappears, e.g. because a spouse chooses to quit their job
- Family living expenses are increasing, perhaps because a child recently started college, and the tuition bill is due
Similarly, your Capital Debt Repayment Margin and Term Debt Coverage Ratio might decrease for any of the above reasons or because your debt obligations have increased. The point is, it’s vital to accurately assess the underlying cause of the problem before taking action to correct repayment capacity issues.
Texas A&M AgriLife Extension’s FARM Assistance program can help you identify repayment capacity issues if/when they exist. For more information about the program and to sign up for assistance, visit the FARM Assistance website.