During the development and compilation of this report, each of the experts interviewed was asked to provide us with 3 questions that their clients should ask when determining whether or not they should move forward with the solutions presented by the experts. Following are the questions the experts say need to be asked by the client and answered by the experts for each of the case studies presented in the September 2015 issue of Farm Equipment.
Questions & Answers by Scott Mickey, Agri-Directions LLC, Sumter, S.C.
1. How much debt load can my operation sustain?
The sustainable debt load of a business depends upon its earnings. EBITDA — Earnings Before Interest, Taxes, Depreciation and Amortization — which is calculated as Operating Revenue minus Operating Expenses. EBITDA represents the money available to spend on family living, interest and debt service. When EBITDA is larger than the amount used for those items, the residual is used to “grow” equity, which could be cash in the bank or funds to purchase other assets.
My recommendation is that interest and term principal payments should be less than 50% of EBITDA. Management should develop a debt plan by first projecting the farm’s future earnings by using the previous 4-year average EBITDA and adjusting upward 3% annually for inflation. In Step 2 we calculate interest and principal payments on existing debt for the next 4 years, as if no new purchases were made.
In Step 3, we calculate the additional debt capacity available by multiplying EBITDA by 50% and subtracting the existing debt payments. Finally, we develop a Capital Expenditure or CapEx Plan based on EBITDA. In a CapEx plan, we are calculating the additional debt that could be serviced, while still keeping the farm’s interest and principal payments to less than half of EBITDA. Additionally, we are looking at what the farm’s capital expenditure needs are for the next several years.
With this information, we can determine if our repayment capacity is sufficient to finance those capital expenditures. If not, we then look to see if there is sufficient EBITDA to make the required down payment and keep the payments below the guideline.
2. How do I establish guidelines for updating equipment?
We develop an asset sheet that shows a summary of the operation’s major equipment, estimating the useable life of each piece and a target date for updating. We try to match the financing terms with the useable life and try not to exceed 4-year terms on used equipment, up to 5, possibly 6 years, on new equipment.
The asset sheet is evaluated in the event of a “buyer's market” and the possibility of updating a piece of machinery at an attractive price before the targeted replacement date. Close attention is given to not biting on “a deal” if it inhibits the ability to replace another piece that's near the end of its use cycle. In the event of a fire sale, we try to trade assets. In other words, if there's a great price on a combine due to be replaced next year and we need to replace a sprayer this year, we attempt to trade assets on the sheet and allow for the savings. The asset plan attempts to finance pieces for the shortest duration possible, overestimate the amount of money it will take to trade each piece and inflate the interest rates to allow some “wiggle room” if needed by finding better prices, longer financing or better rates. The plan doesn't care what brand of equipment is purchased or whether it is new or used. That's up to the discretion of the owner.
3. What can go wrong with this plan?
If earnings don't reach expectations, something has to give, because the goal of keeping interest and principal payments at less than 50% of EBITDA is critical to the health of the business. If earnings lag, debt service may require more than 50% of EBITDA, leaving less available for family living and growth. For this reason, in developing a debt plan, a conservative approach is to allocate only 45% of EBITDA to debt repayment. This results in lower borrowing power, but creates a cushion to keep debts at 50% of EBITDA in years of lower earnings.