During a recent discussion with a farmer he brought up a topic that is on the mind of many farmers: Should I purchase new equipment?
There are a number of ways to look at this question. One of the areas I like to emphasize is replacement capacity. When reviewing replacement capacity, it provides insight into your ability to generate enough funds to make payments on intermediate and long term loans and to replace capital assets. There are two financial measures relevant to repayment capacity. They are term debt coverage ratio and capital replacement and term debt repayment margin.
The term debt coverage ratio measures the ability of the business to cover all term debt payments over a period of time. A number less than 1.0 indicates that the business is not generating sufficient income to meet all of the term debt payments. A number greater than 1.0 indicates the business is generating sufficient income to pay all term debt obligations with some surplus margin remaining. We typically like to see a ratio of at least a 1.25 to a 1.50.
It is important to use cash calculations, and not just net farm income calculations when measuring the term debt coverage ratio. Non cash income measures such as depreciation and inventory changes need to be adjusted. This ratio also includes non-farm income and family living withdrawals, so it cannot be used as a measure of business performance, but is simply an indicator of whether or not there is enough cash to make your term debt payments.
The second way to look at repayment capacity is calculating the Capital Replacement and Term Debt Repayment Margin. This margin is the money left over after all operating expenses, taxes and owner withdrawals have been accounted for. This money is primarily used to replace worn out capital assets. Obviously, the goal is to have a positive margin. This measure is a dollar amount, so it is difficult to compare the measure between farm businesses. The appropriate margin will vary from farm to farm depending on the production and price variability.
If you would like more information on how farm business management can help you understand your Repayment Capacity, please contact one of your area farm business management instructors, Wayne or Rich.
(This information is from Troy Otto, Farm Business Management Instructor, Minnesota West College, Marshall Office)