The Debt to Equity Ratio is a financial metric used to measure the proportion of a farmer’s financing that comes from debt compared to the proportion that comes from equity.
It provides insights into a company’s financial leverage and risk exposure, indicating the extent to which it relies on debt financing to fund its operations and investments.
Debt to Equity Ratio Formula
Debt to Equity Ratio = Total Debt ÷ Total Equity
This article is part of our series on The Key Metrics to Measure Farm Performance.
Description
Calculating the Debt to Equity Ratio
The formula for the debt to equity ratio is:
Debt to Equity Ratio = Total Debt ÷ Total Equity
To calculate the debt-to-equity ratio, you need two key pieces of information: the total debt and the total equity.
Total Debt includes all liabilities or debts owed by the farm, such as loans, mortgages, and other obligations.
Total Equity represents the owner’s investment in the farm, including retained earnings and any additional capital invested.
Both the Total Debt and Total Equity may be found on a farm balance sheet.
Guided Example of the Debt to Equity Ratio
To understand how to calculate the debt to equity ratio, follow this guided example.
Assume that after reviewing the balance sheet, you see that a farm operation has a total liabilities of $500,000 and total owners equity of $1,000,000. With this information, you can calculate the debt to equity ratio.
Debt to Equity Ratio = Total Debt ÷ Total Equity
With this information, you have the financial information necessary to compute the debt to equity ratio.
Debt to Equity Ratio = $500,000 ÷ $1,000,000
Using our formula, we arrive at a debt to equity ratio of 0.5x.
Debt to Equity Ratio = 0.5x
A debt-to-equity ratio of 0.5x indicates that for every dollar of equity invested in the farm, there is 50 cents of debt. This suggests that the farm is financing its operations with a relatively conservative amount of debt compared to its equity. In other words, the farm relies more on its own funds (equity) rather than borrowed funds (debt) to finance its operations.
Ideal Debt to Equity Ratio
The ideal debt to equity ratio for a farmer varies depending on factors such as the farmer’s financial goals, risk tolerance, and industry standards.
Generally speaking, a lower debt to equity ratio is preferred as it indicates a stronger financial position and less reliance on debt.
Using industry benchmarks, most farm operations are in a weak position with a debt to equity ratio above 1.5x, whereas strong farm operations maintain a debt to equity ratio lower than 0.5x.
A higher ratio indicates a lower degree of leverage, which means the farmer is less reliant on debt to finance their assets. While some level of debt can be useful for growth and operations, a higher debt-to-asset ratio can also indicate higher financial risk, as the farmer must ensure enough cash flow to meet debt obligations.
Conversely, a higher ratio suggests that the farmer has a greater equity stake in their operation, potentially indicating a stronger financial position with less reliance on borrowed funds.
How to Improve the Debt to Equity Ratio
Improving the debt-to-equity ratio is crucial for farmers aiming to enhance their financial stability and reduce reliance on external financing. To improve your debt to equity ratio, your strategy should be aimed at either increasing your equity or decreasing your liabilities.
To Increase Equity
- Retained Earnings. Reinvest profits back into the farm rather than distributing them as dividends to increase equity over time.
- Personal Investment. Inject personal funds into the farm as additional equity capital.
- Asset Appreciation. Increase the value of farm assets through improvements, upgrades, or increased productivity, which indirectly boosts equity.
To Decrease Liabilities
- Pay Down Debt in a Timely Manner. Any reputable banker will provide a farmer with adequate financing at adequate terms. Over time, as one decreases debt, the debt to asset ratio will improve.
- Avoid Acquiring New Debt. While sometimes necessary for growth or survival, taking on new debt should be approached with caution. Farmers should evaluate the necessity and terms of new debt carefully to ensure it doesn’t adversely affect their debt-to-asset ratio.
- Negotiate better payment terms. Negotiate longer payment terms with suppliers to delay outgoing payments, thus extending the timeframe for settling accounts payable.
- Refinance short-term debt. Consider refinancing short-term loans with longer-term options to reduce the portion of debt due within the next year, thus lowering current liabilities.
Further Reading
US Department of Agriculture – https://www.ers.usda.gov/data-products/farm-income-and-wealth-statistics/documentation-for-the-farm-sector-financial-ratios/#dtoe
Farm Financial Standards Council – https://ffsc.org/
Basics of a Farm Balance Sheet, Ohio State University – https://ohioline.osu.edu/factsheet/anr-64Farm Financial Analysis Series: Balance Sheet,
Mississippi State University Extension – https://farms.extension.wisc.edu/articles/preparing-a-balance-sheet/