By Ian McLean
This article was first published on Beef Central
A producer going through the process of succession recently asked us the pertinent question ‘how much debt can I afford to take on with the property?’. This is a critical question for all businesses to ask themselves and the answer is unique to each business, however what a bank is prepared to lend you and what debt you can afford will usually be two different figures.
How much debt a business can afford will be a function of its profitability, over what period you would like the debt to be paid off, and what funds the business and family needs after debt servicing costs. A further explanation of each of these factors is below.
The profitability of a business is a function of the operating profit of the business and value of assets used to generate that profit, [profitability = profit/ assets]. While an increase in operating profits will increase profitability, an increase in assets values (75% of the total assets of most Northern Beef Businesses is land) without a corresponding increase in profits, will reduce profitability. The more profitable a business is, the more debt a business can afford.
The period over which you would like debt to be paid off is individual to each business, however there are some principals which are relevant to all.
· Firstly, the biggest determinant of the long-term cost of debt is not the interest rate, but the length of time the principal is outstanding. If you have a million-dollar debt at 6% and repay it over 10 years, 26% of your total repayments will be interest, whereas over 30 years your interest payments will be 54% of total repayments, costing an extra $820,000 in interest alone. In fact, if you borrowed three lots of one million over 30 years, repaying each in 10 years, you would pay less interest than on one loan of one million dollars over 30 years.
· Secondly for debt to be productive it must be earning more than it is costing, unfortunately this is often not the case in agriculture, particularly when just looking at operating returns (with capital gains excluded). Capital gains are an important source of wealth creation in the industry, however there are a couple of major drawbacks of capital gains,
– the gains are on paper only and don’t provide any cash that can be used to service debt or provide for other family needs unless the land is sold, and,
– they can reduce profitability, as detailed above.
This can be where the old chestnut of ‘you are better paying interest than tax’ pops up, but unfortunately this is not usually the case in agriculture. Whilst paying off debt has to come from after tax funds, you only pay tax on those profits once, and you pay interest every year if the debt is not paid off. Also, if you are not getting a return on capital of more than your cost of debt then you will be better off paying down debt.
· Thirdly, how quickly you pay off debt has a big influence on how many opportunities you can take advantage of during your management tenure. If you are highly leveraged with long term debt, then your ability to grow the business will be limited and you will have to let opportunities pass you by. If you can pay off debt over 10 years as detailed above, then you can potentially make 3 or more big moves during your time at the helm.
What funds the family and business need available after servicing debt is an important consideration and unique to each business. Key questions to ask are; what developmental and capital expenditure investment will the business require, what provisioning for drought, school fees, succession and retirement is needed? These areas are which are usually critical to the long-term needs and aspirations of the family, and are also usually underfunded in agriculture.
Back to the initial producer query, below is a brief overview of how we approached the question. The forecast operating profit of the business is $190,000, which accounts for a reasonable wage to the owner. We have used long term cattle prices (refer earlier article on budgeting cattle prices) and an interest rate of 7.5%. Whilst cattle prices and interest rate are both better than those used at the moment, this exercise has a long term (10yrs+) perspective, so we must use long term prices. Basing long term debt or property purchase figures using current cattle prices and interest rates is a recipe for disaster.
We based the numbers on paying the debt off over 20 years and a tax rate of 30%. We decided that the business needs to retain 30% of its operating profits for family and business needs, with the remainder being used for servicing and repaying debt. This is a low number, and effectively means that more than two-thirds of every dollar of profit generated goes towards servicing and repaying debt, leaving less than a third for provisioning for drought, succession, retirement, funding development, intensification and to provide a margin of safety.
Based on the above the business can afford to start with debt at 10% of total assets (or equity at 90% of total assets). At this level the business can pay its owner a reasonable wage, pay the debt off over 20 years, fund interest and tax and retain a small percentage of profits to fund family and business needs. Starting with more debt will mean the business will not be able to afford to do all of the above.
This (debt) figure will seem low to many and at odds with figures often quoted, however the reality of agriculture is that it is a capital-intensive industry, that returns on average low relative returns from the capital. It does not take much leverage therefore for all of the returns to go into debt servicing costs. This is a problem for the industry, with the interest paid by the Northern Beef Industry exceeding profits generated in the long term.
Understanding the financial performance of your business, the debt levels it can afford and whether that debt is productive, are essential skills for successfully managing a modern pastoral business. These skills and many more, are taught in the BusinessEDGE workshop.
The BusinessEDGE workshop was developed by Meat & Livestock Australia to meet producer demand for improved business skills and is delivered across Northern Australia by Bush AgriBusiness Pty Ltd.