What is Your Financial GPS Telling You?
Tuesday, April 17th, 2012
You use GPS receivers to help determine how much fertilizer, weed control, and water is needed in your fields. What are you using for your financial GPS? Like your fields, your finances need the appropriate GPS. Having the right tools both in and out of the fields is crucial for a successful business. In the next few issues, we will discuss several of the underwriting standards lenders use to evaluate the quality of a new loan application as well as what lenders generally consider to be minimum ratios for each standard.
We are beginning the series with the debt coverage ratio (DCR). The DCR is one measure of your operation’s ability to service existing debt. The reason for starting with this ratio is that it is driven by cash flow. While other financial factors are important, no business can exist over a sustained period of time if it does not generate sufficient cash flow to repay its debts, and cover taxes and living expenses. Your federal income tax return is the basis for developing this analysis from a historical perspective. The projected cash flow is the basis for the current year’s analysis.
The DCR is determined by dividing an operation’s cash available for debt service, both farm and nonfarm, by the total of all principal and interest payments, called the debt service requirement. For most loan approvals without an FSA guarantee, this ratio needs to be 1.25 or higher, based on at least three years of history and the current year’s projection. That is, the cash available needs to exceed the debt service requirement by at least 25 percent for the four‐year average, and for the projection year alone.
The historical cash available is basically determined by taking your federal income tax returns “Total Income”; adding interest and depreciation from the applicable tax schedules and forms, such as Schedule F, and also from the tax returns for entities such as LLC’s and partnerships; and subtracting nonrecurring capital gains, federal and state income taxes, and estimated living expenses. The projected cash available comes from the cash flow projections for an average operating year.
To determine the debt service requirement, your lender will add up the annual payments (principal and interest) for both business (farm and non‐farm) and personal loans/debts, and then add the annual farm operating loan interest. Personal debts may include such things as residential and vehicle loans, and credit cards that are not paid off in full on a monthly basis.
An average DCR of 1.25 usually provides adequate cushion for those years when cash flow is below normal. This level of coverage indicates that your operation can have below normal income and/or expenses that are above average, and still be likely to service all its obligations without having to increase debt. This level of debt coverage also allows the farming operation to build equity over time. The cash that is not required for debt service can be used to build a cash reserve, to reduce operating loan needs or accelerate loan principal payments, or as a down payment on an asset purchase.
You use GPS data to help decide what is best for your crops, why wouldn’t you use the same vigor when determining your financial GPS? American Farm Mortgage has created a worksheet to help you develop your annual cash flow, and the resulting DCR. If you are interested in a copy of this worksheet, please contact one of our experienced Loan Underwriters at 800‐876‐2362.