The debt coverage ratio tells
use whether a farmer or rancher is more likely to be able to pay debt
obligations due in the coming year. Read on to learn more!
The debt coverage ratio is one of the key repayment capacity ratios used in farm financial analysis.
Debt Coverage Ratio Formula
Debt Coverage Ratio = Net Operating Income ÷ Total Debt Service
This article is a part of our series on Farm Financial Performance Ratios.
Description
The debt coverage ratio in farm financials is a measure of a farm’s ability to cover its debt obligations with its operating income. It assesses the farm’s ability to generate enough operating income to meet its debt service requirements, including interest payments and principal repayments.
A ratio greater than 1 indicates that the farm generates enough operating income to cover its debt obligations. A higher ratio suggests a stronger ability to service debt and a lower risk of default.
A ratio less than 1 suggests that the farm may struggle to meet its debt obligations with its operating income alone, indicating potential financial stress and a higher risk of default.
This ratio is used most often by banks and lenders to assess whether the farmer or rancher is able to cover their loan payments.
Calculating the Rate of Return on Farm Assets
There are many different ways that the debt coverage ratio is calculated, however, in its most basic form, the formula divides Net Operating Income by the Total Debt Service.
Debt Coverage Ratio = Net Operating Income ÷ Total Debt Service
To calculate this ratio, you will need to locate both Net Farm Income and the Total Debt Service.
Net Operating Income is the farm’s operating income after deducting operating expenses but before deducting interest, taxes, depreciation, and amortization (EBITDA).
Total Debt Service includes all debt-related obligations, such as interest payments, principal repayments, and any other debt-related expenses.
A full breakdown of the Net Operating Income and the Total Debt Service can be found in the farm income statement.
Guided Example
To understand a working example of the debt coverage ratio, consider the following example. A farmer has:
- Total revenue of $1,000,000.
- Operating costs of $500,000.
- A line of credit and a term loan where the Principal & Interest Payment is $100,000 per year.
With these numbers, we can find the debt coverage ratio of the farm operation.
To calculate the debt coverage ratio, start by taking our formula:
Debt Coverage Ratio = Net Operating Income ÷ Total Debt Service
Remember that net operating income will be the total revenue minus the operating costs, or $500,000.
Net Operating Income = Total Revenue – Operating Costs
Net Operating Income = $1,000,000 – $500,000
Net Operating Income = $500,000
Next, plug the net operating income and the total debt service payment into the formula:
Debt Coverage Ratio = Net Operating Income ÷ Total Debt Service
Debt Coverage Ratio = $500,000 ÷ $100,000
Debt Coverage Ratio = 5.0x
What this tells us is that the farmer is generating 5.0x the amount of operating income to cover debt service costs, which is very good!
Ideal Rate of Debt Coverage Ratio for Farmers
The ideal debt coverage ratio varies depending on factors such as industry norms, economic conditions, and the lender’s risk tolerance. However, the following guidelines can help identify a healthy level.
Based upon benchmarks within the agriculture industry, a good debt coverage ratio exceeds 1.25x. Very well managed farm operations have a debt coverage ratio exceeding 1.75x or greater.
- A ratio greater than 1.00x is crucial! It helps ensure the farmer can repay their minimum debt amounts.
- A ratio greater than 1.25x is healthy – meaning there is ample coverage and some margin or buffer.
- A ratio greater than 1.75x is strong. This provides a lot of buffer and may indicate the ability to take on additional debt, if warranted.
Generally speaking, borrowers should aim to achieve a debt coverage ratio that provides sufficient cushion to cover debt obligations comfortably and meets lender requirements.
Improving the debt coverage ratio (DCR) involves strategies aimed at increasing operating income, improving margins or reducing debt obligations. Preferably the farmer or rancher will consider all three.
Increase Operating Income
- Increase Revenue. Explore opportunities to increase farm revenue through product diversification, value-added products, or expanding into new markets.
- Improve Operational Efficiency. Streamline operations, optimize resource utilization, and invest in technology to increase productivity and profitability.
- Cost Reduction Identify and eliminate unnecessary expenses, negotiate better pricing with suppliers, and implement cost-saving measures to improve profitability.
Enhance Profit Margins
- Focus on High-Margin Products. Prioritize products with higher profit margins to increase overall profitability per unit of sales.
- Value-Added Services. Offer value-added services or products to command premium prices and increase profit margins.
- Price Optimization. Review pricing strategies and adjust pricing levels to maximize revenue and profit margins while remaining competitive in the market.
Debt Management
- Refinance Debt. Explore options to refinance existing debt at lower interest rates or longer repayment terms to reduce debt service obligations.
- Debt Restructuring. Negotiate with lenders to restructure debt terms, such as extending repayment periods or reducing interest rates, to improve cash flow and reduce debt burdens.
- Debt Consolidation. Consolidate multiple debt obligations into a single loan with more favorable terms and lower overall debt service requirements.
How the Debt Coverage Ratio is Used
The debt service coverage ratio is one of the most important financial ratios used by banks and lenders to determine whether a farmer can repay their debt obligations.
Generally speaking, the higher the debt coverage ratio, the better. If the debt coverage ratio falls to 1 or lower, this means there is a real risk that the lender will not be repaid, and ultimately may force the farmer into foreclosure or seize property in extreme cases.
Additionally, the ratio also helps farmers and ranchers understand if they have the capacity to take on greater amounts of debt. Debt is not inherently a bad thing as long as the proceeds from the debt are used for economically viable purposes. When reviewing their capacity, the farmer may determine they can take on more debt to finance operations.
Variations on the Debt Service Coverage Ratio
Very common that some banks, lenders and financial analysts will deviate from the simple formula above. Anecdotally, the author has seen at least 12 variations on this one formula and many institutions interpret this differently.
Many variations may add back non-cash expenses to the Debt Coverage Ratio, such as depreciation and amortization. This may give a better cash flow based overview of the debt coverage ratio.
Other variations on this ratio include:
Fixed Charge Coverage Ratio (FCCR)
The fixed charge coverage ratio measures a borrower’s ability to cover all fixed charges, including both debt service and lease payments. It provides a broader view of a borrower’s financial health by considering all fixed obligations. The formula is:
Fixed Charge Coverage Ratio = (EBITDA + Lease Payments) ÷ (Total Debt Service + Lease Payments)
Global Debt Service Coverage Ratio (GDSCR)
The global debt service coverage ratio expands the analysis beyond a single loan or debt obligation to include all debt obligations of the borrower. It compares the borrower’s total cash flow available for debt service to their total debt service, providing a more comprehensive view of the borrower’s overall debt servicing capacity.
Adjusted Debt Service Coverage Ratio (ADSCR)
The adjusted debt service coverage ratio incorporates additional adjustments to the numerator (net operating income) and/or denominator (total debt service) to provide a more accurate reflection of the borrower’s ability to service debt.
Interest Coverage Ratio (ICR)
The interest coverage ratio focuses specifically on a borrower’s ability to cover interest payments with their operating income. It is commonly used by lenders to assess the borrower’s ability to meet interest obligations. The formula is:
Interest Coverage Ratio = Interest Expense ÷ EBIT
These variations on the debt service coverage ratio provide lenders and borrowers with additional insights into the borrower’s financial health, debt servicing capacity, and risk profile. By considering these variations, lenders can make more informed lending decisions, while borrowers can better understand their financial position and plan for future debt obligations
Further Reading
Farm Financial Standards Council – https://ffsc.org/
Basics of a Farm Balance Sheet, Ohio State University – https://ohioline.osu.edu/factsheet/anr-64
Farm Financial Analysis Series: Balance Sheet, Mississippi State University Extension – https://farms.extension.wisc.edu/articles/preparing-a-balance-sheet/