“How much debt can I afford to take on with my property?”
This is a critical question for all cattle producers to ask themselves, and the answer is unique to each business.
However, what a bank is prepared to lend a producer, and what debt that producer 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 the debt is 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 set-out 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 (75pc of the total assets of most northern Australian 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 a producer 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 6pc and repay it over 10 years, 26pc of the total repayments will be interest, whereas over 30 years, interest payments will be 54pc 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 always 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, tax is only paid on those profits once, while you pay interest every year if the debt is not paid off. Also, if a producer is not getting a return on capital of more than their cost of debt then they will be better off paying down debt.
- Thirdly, how quickly debt is paid off has a big influence on how many opportunities a producer can take advantage of during their management tenure. If they are highly leveraged with long term debt, then their ability to grow the business will be limited and they will have to let opportunities pass them by. If the debt can be paid off over 10 years as detailed above, then there’s potential to make three or more big moves during the 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 question raised in our intro, below is a brief overview of how the question can be approached.
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 Beef Central article on budgeting cattle prices) and an interest rate of 7.5pc. 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 30pc. We decided that the business needs to retain 30pc 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 10pc of total assets (or equity at 90pc 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. 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.
Essential skills covered in BusinessEDGE workshops
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*.
Bush AgriBusiness has scheduled a series of BusinessEDGE workshops in early 2017, which present a significant professional development opportunity for those in the Pastoral Industry.
The upcoming workshop dates and locations include:
- Brisbane QLD – Thursday & Friday 16-17 Feb
- Lake Nash Station NT – Tuesday & Wednesday 23-24 Feb
- Blackall QLD – Monday & Tuesday 27-28 Feb
- Georgetown QLD – Tuesday & Wednesday 21-22 March
- Mackay QLD – Tuesday & Wednesday 13-14 June
- Darwin NT – Tuesday & Wednesday 20-21t June.
There is a discount for multiple participants from a business and an early bird discount for registrations received four weeks prior to the workshop. The BusinessEDGE comes with a full money back guarantee and participants are provided with a suite of take home tools to apply to their own business, as well as comprehensive reference material.
- For registration or more information, go to www.babusiness.com.au/thebusinessedge
- There is also a publication on ‘Improving the performance of Northern Beef Enterprises’ available for download.