{"id":3713,"date":"2024-11-22T14:00:50","date_gmt":"2024-11-22T20:00:50","guid":{"rendered":"https:\/\/agrilife.org\/agecon\/?p=3713"},"modified":"2024-11-22T14:00:50","modified_gmt":"2024-11-22T20:00:50","slug":"using-financial-ratios-to-manage-debt-part-2","status":"publish","type":"post","link":"https:\/\/agrilife.org\/agecon\/using-financial-ratios-to-manage-debt-part-2\/","title":{"rendered":"Using Financial Ratios to Manage Debt, part 2"},"content":{"rendered":"

\"FourDoes your business generate enough income to make scheduled debt and lease payments?\u00a0 If necessary, could that income also cover payments on additional debt?\u00a0 In today\u2019s post, we\u2019ll look at a set of financial measures that can help you answer these important questions.<\/p>\n

Understanding Your Repayment Capacity<\/h3>\n

Two weeks ago, I discussed why it is important to monitor solvency, along with some measures you can use to do so.\u00a0 Today I\u2019ll discuss measures of repayment capacity, which focus on two things.\u00a0 First, repayment capacity measures your ability to make scheduled debt payments on time using income from your business.\u00a0 If your business doesn\u2019t generate enough income to make these payments, you\u2019ll have to make up the difference with funds from other sources.\u00a0 If your repayment capacity is insufficient to make scheduled payments for long enough, you run the risk of eroding your business\u2019s equity to the point of insolvency.<\/p>\n

Repayment capacity also measures your ability to purchase or finance new capital assets for the business.\u00a0 Over time, assets like machinery, vehicles, and livestock must be replaced. \u00a0If you\u2019re not able to finance these investments when they are needed, your business\u2019 profitability may suffer.\u00a0 The measures of repayment capacity that I\u2019ll discuss here will tell you if you can finance those purchases when they are necessary.<\/p>\n

Where to Find the Information You Need<\/h3>\n

The information you need to measure repayment capacity comes from multiple sources.\u00a0 First, you will need your business\u2019 current balance sheet and income statement.\u00a0 These documents will provide information on the business\u2019 income and on the business\u2019 current debt situation.<\/p>\n

In addition to these two financial statements, you will need information on your family\u2019s living expenses and income tax liability.\u00a0 The tax information will come from your tax records.\u00a0 Information on family living expenses comes from your personal banking records or, if you have one, your family\u2019s budget.<\/p>\n

How to Measure Repayment Capacity<\/h3>\n

The Farm Financial Standards Council<\/a> suggests tracking five measures related to repayment capacity.\u00a0 I\u2019ll cover three of these measures here, starting with Capital Debt Repayment Capacity.<\/p>\n

Your farm\u2019s Capital Debt Repayment Capacity<\/strong> measures how much cash is available to make scheduled debt payments and to make purchases to replace capital assets.\u00a0 You can use the following formula to calculate this measure:<\/p>\n

Net Farm Income
\n<\/em>+ Depreciation
\n<\/em>+ Net Non-Farm Income
\n<\/em>\u2212 Family Living Expenses & Income Taxes
\n<\/em>+ Interest Expenses on Term Loans<\/em><\/p>\n

Capital Debt Repayment Capacity is the starting point for all other repayment capacity measures.<\/p>\n

The next repayment capacity measure is your Capital Debt Repayment Margin<\/strong>.\u00a0 This measure tells you how much money is left over after all scheduled debt payments are made.\u00a0 What\u2019s left over is what\u2019s available to purchase or finance new capital assets, should they be necessary.\u00a0 Calculate Capital Debt Repayment Margin as:<\/p>\n

Capital Debt Repayment Capacity
\n<\/em>\u2212 Scheduled principle & interest payments on term debt<\/em><\/p>\n

Finally, the Term Debt Coverage Ratio<\/strong> measures your repayment capacity relative to the size of your scheduled debt payments.\u00a0 Calculate this measure as:<\/p>\n

Capital Debt Repayment Capacity
\n<\/em>\u00f7 Scheduled principle & interest payments on term debt<\/em><\/p>\n

A Term Debt Coverage Ratio of exactly 1.00 indicates that your business income is equal to the size of your scheduled debt payments.\u00a0 You can make all scheduled payments, but you have no margin with which to purchase or finance new capital assets.\u00a0 If your Term Debt Coverage Ratio is less than 1.00 then your business\u2019 income is not sufficient to cover all scheduled debt payments.\u00a0 In general, it\u2019s a good idea to aim for a ratio greater than 1.75.\u00a0 A ratio value less than 1.25 indicates that your business may soon find making scheduled debt payments difficult.<\/p>\n

Repayment Capacity and Debt Management<\/h3>\n

Keeping track of repayment capacity can help you manage your borrowing decisions so that you don\u2019t put the solvency of your business at risk.\u00a0 Whenever possible, seek to maintain a healthy Capital Debt Repayment Margin and Term Debt Coverage Ratio.\u00a0 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.<\/p>\n

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.\u00a0 If any of these factors begin to erode your repayment capacity, consider ways to address the problem before they impact your business\u2019 financial position.<\/p>\n

How to Improve Your Repayment Capacity<\/h3>\n

Repayment capacity issues are normally caused by problems elsewhere in your business or personal finances.\u00a0 For example, your Capital Debt Repayment Capacity value might decrease for one of three reasons:<\/p>\n