Manage Debt to Your Advantage

By Dr. Dennis DiPietre and published by PigCHAMP - One of the most basic ideas in the wise use and management of debt is something called debt structure. It’s a good time to review this concept since many producers have been paying down debt rapidly in the last 19 months and are beginning to take debt on again, often under different terms or perhaps a new loan agreement.
calendar icon 16 December 2005
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How you decide to use debt, manage the cost of debt and choose to structure debt are key to long-term success and the avoidance of problems years from today.

As most producers know, the usefulness and/or life of the asset you acquire through debt must be longer than the terms of the debt itself. If that doesn’t occur, you go “upside down” on the asset: owing more than the value of the asset or the value that the asset can deliver to pay scheduled debt. This often happens to people who buy new or used cars and structure their repayment for five or six years. Even though the vehicle may retain its value well, the pattern of decline is almost always more rapid than debt reduction. Most loans are structured in such a way that the bulk of the first payments are interest with a small contribution to principal. The last payments are almost all principal with very little interest. However, depreciation in value, even if it is near linear, will still outrun the balance owed to the bank unless terms are shorter (sometimes substantially shorter) than the useful life of the asset.

The same principles apply to how debt should be structured for farm assets. Even though most lenders will ensure that term debt is structured so that there is a comfortable margin between balance owed and value left in the asset, that is not guaranteed. Producers must be careful to manage this process and not be passive with respect to the terms of debt. Many producers use lines of credit to initially acquire assets and then roll them over into term debt at the time the structures or equipment are actually in place. This is fine as long as the follow through is there to move capital purchases out of lines of credit with short terms. Many producers forget or fail to do this second step and then they wind up carrying capital items in the short term notes.

When capital debt is retained in the line of credit, the financial ratios used to evaluate solvency and liquidity become skewed. Not only does this potentially cause problems with acquiring additional debt, but it can limit the producer’s ability to switch lenders if that becomes a favorable option. For instance, the current ratio is a key financial ratio which gives guidance on the farm’s ability to meet short-term debt obligations as they become due. The current ratio is measured as the ratio of current assets to current liabilities. Since long term assets purchased on short term debt do not appear as current assets on the balance sheet, the numerator of the ratio (current liabilities) will appear large compared to the current assets (such as inventory and cash on hand) and will signal potential short-term repayment problems. Depending on how much capital is in the line of credit, the regular sale of inventory and cash on hand in the next year may appear to be insufficient to pay the line.

In addition, the longer capital items remain in the line, the more difficult it is to sort them out and to apply some form of reasonable amortization to them. If they have been there for several years, tracing these entire sets of purchases out can be very difficult. Mounting lines of credit debt without corresponding increases in inventory makes it appear that losses are accumulating in the line rather than capital assets. This presents a problem if you desire to shop your debt to other lenders.

Failing to properly structure farm debt also leads to problems evaluating the performance of the farm using managerial accounting and cost of production analysis. It is not simply a technicality affecting lenders. The balance sheet is an important tool for internally managing the farm and tracking cost of production. When the record gets blurred through inattention to proper debt management, the ability of the producer to use the balance sheet to make informed decisions about the future is diminished. This issue is not an isolated problem among producers, so before you get ready for a long winter’s nap, it might be wise to examine your balance sheet carefully as you prepare end-of-year financials and focus on how you have structured your purchases of capital items.

Source: PigCHAMP - December 2005

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