Use debt effectively

Debt and farming have a complex and sometimes unhealthy relationship.  Some farms appear to be drowning in debt with liabilities far exceeding the capacity to pay down the interest and principle. Other farm debt problems relate to a particular asset, such as a tractor. 

In other situations, the polar opposite is in effect.  The operation has religiously avoided debt, but farm gates sales alone are too small to retain sufficient earnings to purchase of equipment and resources.  The farm may be annually profitable, but may have a short life due to the inability to increase efficiency, reduce labour, expand production or invest in equipment for post-harvest storage or processing.,

Like an organic transition, the key to managing debt effectively is to be informed, be in control and do the paperwork and analysis required to make the best decision possible.  When used effectively, debt can be a powerful tool and instead of increasing your risks, it can reduce them by providing cost certainty, enable you to acquire assets to grow the business and preserve your working capital and strategic reserve.

Good Debt vs. Bad Debt

All debt is not bad.  Good debt can be defined as "debt on assets that are earning income for you at a rate greater than the cost (interest) on the debt".   The Return on Investment (ROI) must consider the interest of the loan, as well as the declining value of the asset.  For example, if the loan is carrying an interest rate of 7%, the money is used to finance an enterprise that produces a 15% rate of return, then it is good debt.  If the loan is for a piece of equipment earning only 2% ROI, it is bad debt.

In addition to positive financial returns, good debt includes loans for things you absolutely need to operate the business, but can’t cover without depleting your working capital and strategic reserves.  Lease or principal/interest payments should be sized to fit your monthly cash flow, with provisions made for changing rates. 

In personal situations examples of good debt can include a home mortgage, student loan to advance education and earning power, or a business loan.  Examples of bad debt can include making purchases on credit cards and paying interest, loans for optional equipment that does not generate a significant return or impact on the business, toys, and monthly payments that mess up your cashflow. Debt should be approached as a tool to grow your farm business, not as a substitute for poor cash flow.    

The following tools can be useful to manage, monitor and make informed decisions about your debt.  They can provide indications of performance and risk.  Debt should be approached as part of your overall farm financial planning and budgeting. 

AGMRC Debt Analysis Tools www.agmrc.org/agmrc/business/operatingbusiness/debtanalysistools.htm

AGMRC Interpreting Financial Performance Measures
www.agmrc.org/agmrc/business/operatingbusiness/interpretingfinancialperformancemeasures.htm

Dr. David Kohl - Back to the Basics with Benchmarking
http://www.ext.vt.edu/news/periodicals/fmu/1997-02/benchmark.html

Ag Island Survivor Series – Can you use your business survival tools to survive and thrive on Ag Island?
CFBMC Ag Excellence 2008 Presentation
http://www.farmcentre.com/Documents/Events/Excellence2008/Ag-Island-Survivor-Series.pdf