Using debt effectively on the farm
With commodity prices showing some signs of positive returns on most farming enterprises, I have had a number of students ask me where to stash some of that extra cash. Beyond building working capital, most producers have either considered paying down debt or borrowing additional debt to make capital purchases.
While we need to be cautious in our approach toward debt, we also need to realize its role in our business. On one hand, an overwhelming insistence on becoming and remaining debt free can be a major obstacle to growth and profitability. We often confuse being debt free with financial security. However, improper use of debt can and does kill a business.
Our first lesson is to understand the difference between economics and finance. In economics the issue is profit. In finance, the issue is cash flow. If economics is the engine of the business, then finance is the fuel that makes the business go.
When a business is profitable, it pays to leverage our money through borrowing. When the business is unprofitable, borrowing only increases the loss. The greater the degree of leverage, the greater the potential return or loss on your money.
However, we can get too much of a good thing. Too much leverage can leave a business overly vulnerable to risk. The degree of leverage that is reasonably safe depends on the risk of investment. Before plunging into any major decisions, you should review your solvency and profitability ratios and develop a projected cash flow budget. Solvency tells us the degree to which a business is leveraged and indicates a business's ability to withstand risk. Profitability tells us the strength of the economic engine that drives the business. The projected cash flow budget tells us how the debt will be repaid. The moral of the story is if the business is economically sound, it can be more profitable by borrowing judiciously, but it must be profitable and it must cash flow. For long term security, economics come first!
For additional information on determining ratios and preparing a cash flow plan, the Farm Business Management Program and a list of instructors near you can be found at www.fbm.mnscu.edu.