The debt to asset ratio tells us how much a farmer’s assets, such as land and equipment, is financed as opposed to owned.
The debt to asset ratio is one of the solvency ratios used in farm financial analysis.
Debt to Asset Ratio Formula
Debt to Asset Ratio = Total Liabilities ÷ Total Assets
This article is a part of our series on Farm Financial Performance Ratios.
Description
The debt-to-asset ratio in agricultural finance is a financial metric used to assess the financial leverage and health of an agricultural business.
It measures the proportion of a company’s assets that are financed by debt, offering insight into the level of financial risk the business is taking on. The ratio is calculated by dividing the total liabilities (debt) of the agricultural business by its total assets.
A higher ratio indicates a higher degree of leverage, which means the farmer is more 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 lower ratio suggests that the farmer has a greater equity stake in their assets, potentially indicating a stronger financial position with less reliance on borrowed funds.
Calculating the Debt to Asset Ratio
The debt-to-asset ratio is calculated by dividing the total liabilities by the total assets.
Debt to Asset Ratio = Total Liabilities ÷ Total Assets
To determine the debt to asset ratio, you will need to find the Total Assets and Total Liabilities on a balance sheet.
Assets typically include items such as cash, inventory, livestock, land, machinery and equipment. Generally this is anything which is owned by the farmer.
Debts are obligations due are to be paid in the future. These can include things like such as accounts payable, short-term loans, and long-term loans.
A full breakdown of Assets and Debts can be found on an agricultural balance sheet.
Guided Example
Say for example, John, a farmer, has total assets of $500,000, which can be a combination of current and non-current assets. Also assume that he has $200,000 in outstanding loans.
To calculate a debt to asset ratio, start by taking our formula:
Debt to Asset Ratio = Total Debt ÷ Total Assets
Then plug in the total debt and total assets:
Debt to Asset Ratio = $200,000 ÷ $500,000
Using our formula, we arrive at 40% as the debt to asset ratio.
40% = $200,000 ÷ $500,000
What this tells us is that 40% of John’s assets have been financed in some way with debt.
Ideal Debt to Asset Ratio for Farmers & Ranchers
Due to wide variation in the agriculture industry and the unique needs of each farmer, there isn’t a single ideal Debt to Asset Ratio.
However, attaining a debt to asset ratio of less than 60% is ideal in the majority of situations.
Ideally, the debt to asset ratio should be less than 60%, meaning that fewer that 60% of assets are covered by debt. Anything higher may indicate significant overleveraging and risk of overleverage on the part of the borrower.
To create a margin for safety, farmers should strive to have a debt to asset ratio of at less than 60%, however, the smaller this number the better. Anything below 30% is excellent for a debt to asset ratio and indicates that less of the farmers assets are covered by debt.
How to Improve Your Debt to Asset Ratio
Improving the debt-to-asset ratio is crucial for farmers aiming to enhance their financial stability and reduce reliance on external financing. To improve your debt to asset ratio, your strategy should be aimed at either increasing your assets or decreasing your liabilities.
To Decrease Debts
- 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.
To Increase Assets
The most critical part is making sure that the farmer
invests in assets that are economically useful. Meaning that the ownership of
that asset provides a positive return. Investing in assets that will appreciate
in value over time or increase revenue can improve the total assets over the
long term, contributing to a better debt-to-asset ratio. This could include
investing in high-quality land or technology that boosts productivity.
How the Debt to Asset Ratio is Used
The debt to asset ratio is a crucial financial metric that measures the proportion of a company’s assets that are financed by debt. This ratio is important for several reasons, particularly in assessing a company’s financial health, risk level, and operational efficiency.
Farmers and Ranchers us the debt to asset ratio to understand the overall health of their operation. If the debt to asset ratio continues to grow, that is a sign that a higher and higher proportion of debt is used to provide the capital to run the operation.
Higher debt means higher interest payments. While debt in some cases can be beneficial, it is important to keep the debt to a reasonable and economically sustainable level.
Similarly, lenders use the debt to asset ratio to assess the overall debt burden placed upon a farmer. This debt in turn must be sustained by the operation.
If a farmer is over encumbered, also called overleveraged, there is risk of default. This is especially true if there are adverse conditions which impact the borrower. Conversely, farmers and ranchers borrowing from a bank may get preferred or better rates when the lender knows there is less debt and a greater certainty of repayment.