Farm debt needs to be monitored closely so that it does not become an unmanageable snow ball. There are different ways for monitoring debt status. One of them is the debt to asset percentage. To calculate your debt to asset percentage, simply get your last balance sheet and divide your total debt (or total liabilities) by the total assets and multiply by 100. A debt to asset ratio of 35% implies that for every $100 of assets the farm owns, the farm still needs to pay $35 to a lending source. In general terms, a good debt status implies a debt to asset percentage below 30%, whereas a poor debt status implies a debt to asset percentage above 70%.
In addition to the debt to asset percentage, it is not unusual to hear other indicators in more lay conversations. One of these indicators is the debt per cow. In a recent conference organized by Virginia Cooperative Extension farmers were ask to respond anonymously what was the maximum debt per cow they feel comfortable to have at their farm. The responses were quite variable (see figure), ranging from absolutely no debt for some conservative farmers to as high as $8,000/cow for some others.
Many flaws exist about using debt per cow as a key financial indicator. First of all, it does not reflect the debt position relative to the assets of the farm. Also, the debt per cow being high or low can depend on the scenario of analysis. Very likely a newly expanded farm might have much higher debt per cow than a well-established one. Finally, the comfort zone in regards to debt per cow can also depend on the age of the farm manager, as mature managers might be more conservative than young managers when taking debt.
A good way of classifying debt per cow as low or high, or as risky and non-risky, is putting some perspective to whatever the number implies. Assuming that the rolling herd average of a cow is 28,000 lb/ cow and that milk price is $19/cwt, then the yearly revenue is $5,320/cow. Considering an operating cost of production equal to $15/cwt, then the earnings before interests, taxes, depreciation and amortization (EBITDA) are $1,120/cow. After paying $335/cow for income taxes the farm has $785/cow of earnings available for debt payments, capital replacement (depreciation & amortization), and family living. Assuming an interest rate of 4.5% APR on loans, the remaining cash to pay depreciation, amortization, family withdrawals, and principal payments can be $650/cow when debt is $3,000/cow or as low as $425/ cow when debt is $8,000/cow. Assuming the unrealistic scenario in which all remaining cash is used to pay just principal, in the former case it would take 4.6 years to pay in full a debt of $3,000/cow, whereas in the latter case it would take at least 19 years to pay in full a debt of $8,000/cow. It is worth mentioning these estimates assume no more debt is taken.
In conclusion, monitor your debt frequently and carefully. The higher your debt level, the higher the percentage of your milk check that is already committed to pay debt. Monitor your debt to asset percentage, among other key financial indicators. Finally, be aware that debt per cow is not the best indicator to monitor your debt as there are many variables masking its usefulness.
Virginia Cooperative Extension materials are available for public use, reprint, or citation without further permission, provided the use includes credit to the author and to Virginia Cooperative Extension, Virginia Tech, and Virginia State University.
Issued in furtherance of Cooperative Extension work, Virginia Polytechnic Institute and State University, Virginia State University, and the U.S. Department of Agriculture cooperating. Edwin J. Jones, Director, Virginia Cooperative Extension, Virginia Tech, Blacksburg; M. Ray McKinnie, Administrator, 1890 Extension Program, Virginia State University, Petersburg.
February 28, 2017