How Current is Your Financial GPS?
Tuesday, April 24th, 2012
Our last article discussed the debt coverage ratio, how it is calculated and how it is analyzed. Our series continues with the discussion of two more underwriting standards used in analyzing a new loan request or an existing loan; the debt to asset (DTA) ratio and loan to value (LTV).
The debt to asset ratio is a measure of an operation’s leverage and solvency. Leverage is the use of debt for investment purposes and solvency is the operation’s ability to satisfy all of its obligations by selling assets. Primarily a measure used by lenders, the debt to asset ratio can be helpful to operators. One thing to keep in mind is that debt to asset does not measure or address repayment ability or cash flow.
The debt to asset ratio is calculated by dividing the total liabilities from the consolidated, market value balance sheet, by the total assets from the same balance sheet. The result is usually expressed as a percentage. In other words, if an operation has total liabilities of $45,000 and total assets of $100,000, the debt to asset ratio of the operation is 45%. For every $1.00 of assets, the operation has $0.45 of debt.
Just as the balance sheet is a “point in time” or snapshot of the operation as of a certain date, so is the debt to asset ratio. While assessing the debt to asset ratio from one balance sheet can be useful, often the more meaningful way of analyzing debt to asset is by the trends calculated from historical, evendated, market value balance sheets. This is the reason completing a balance sheet on the same day every year, preferably 12/31, is important. If the trend shows a decreasing debt to asset, this can indicate one or a combination of several things. It could indicate the operation is making money and increasing assets or paying down debt with the cash. It could also mean the operation’s balance sheet reflects higher real estate values than prior years. Often, a decreasing debt to asset trend is a combination of these scenarios.
As mentioned above, one of the factors that can affect debt to asset is increasing the value of real estate on balance sheets. While this can lower debt to asset, it also influences net worth. Net worth is calculated using the same components as debt to asset but net worth is the difference between total assets and total liabilities. This typical method of calculating net worth includes asset appreciation and earnings in the result.
There is a second type of net worth that excludes asset appreciation. This is called earned net worth. Earned net worth is calculated using the difference between total assets and total liabilities while adjusting intermediate and long term asset values, such as machinery and real estate, to their cost. The net worth is then subtracted from the prior year’s net worth to derive the earned net worth. For example, if this year’s balance sheet indicates a net worth of $600,000 and last year’s balance sheet indicates a net worth of $500,000, the earned net worth is $100,000. By adjusting the asset values to cost, the increase in net worth is the value that was earned as opposed to being gained from appreciation. Although calculating earned net worth takes more time and work, it is usually worth the extra effort. Individuals and entities that are consistently earning net worth tend to be more viable in the long term than those gaining net worth from only appreciation.
When analyzing debt to asset ratios, it is important to maintain perspective and understand the absolute and relative relationships associated with the measure. A debt to asset of 50% for a particular operation does not necessarily indicate that the operation is financially weaker than an operation with a 20% debt to asset ratio. Absolutely, the operation with a 50% debt to asset is more leveraged than the operation with a 20% debt to asset. Relatively, it could be that the more leveraged operation is a beginning or less mature operation but is generating more cash and is a stronger overall operation. Considering the trends along with the absolute and the relative relationships can often be enlightening when analyzing an operation’s debt to asset ratio.
For most non FSA Guaranteed loans, the standard for debt to asset is 50% or less. Operations that have facilities such as dairies or confinement operations are sometimes allowed a higher debt to asset ratio. On a new loan request, the debt to asset is calculated from the proforma balance sheet and compared to the standard. The proforma balance sheet is the balance sheet that is expected to exist immediately after the loan transaction occurs.
Since the debt to asset ratio is calculated from the operation’s internal balance sheets, it is important that the balance sheets be complete and accurate. Financial measures calculated from balance sheets are only as accurate as the balance sheets themselves.
Loan to value is a simple calculation used by lenders to measure their collateral position.Loan to value is calculated by dividing the loan amount by the value of the collateral securing the loan. The loan to value is typically expressed as a percentage. For example, a $500,000 loan secured by $1,000,000 of collateral would have a loan to value of 50%. The typical loan to value standard is 65‐70% or less.
When working with your finances, make sure you are prepared and understand the items your lender is looking for. You wouldn’t treat your crops without first having an action plan, why wouldn’t you use the same mentality when deciding if your financial GPS is up‐to‐date? If you have any questions please contact one of our experienced Loan Underwriters at 800‐876‐2362.
American Farm Mortgage Company (AFMC) is a nationwide ag real estate lender specializing in Full Time Farm Loans and Farm Service Agency Guaranteed Loans. AFMC’s strong relationships with secondary market investors enable us to offer an extensive range of products to fit most agricultural real estate financing needs. For more information, call us at (800) 876‐2362 or visit our website at www.americanfarmmortgage.com.