Conceptual Basis of Debt Repayment Capacity Utilization (DRCU)
Measurement
There are several approaches used by ERS to measure farm business
debt repayment capacity. All are conceptually based
on a reasonable level for the term debt and capital lease coverage
ratio, as recommended by the Farm Financial Standards Council.
This debt coverage ratio measures income available for debt coverage
relative to required debt service payments. Income available for
debt coverage measures the farm and/or nonfarm income that is available,
after meeting all cash expenses, to make principal and interest
payments on debt, and to provide a reasonable margin for capital
replacement and contingencies.
While financial statements for individual farm operators can be
used to determine their individual income available for debt coverage,
a variation of this measure can also be determined for the farm
sector. For individual farm businesses, the income
available for debt coverage from farming operations is defined as
net farm income plus depreciation plus interest on term debt. For
farm operator households, this measure can be extended to include
the operator's income from both farm and nonfarm sources, adjusted
for family living expenses and income taxes. Several assumptions
can also be applied to add a capital lease component. For the farm
sector, the income available for debt coverage is defined as net
cash income plus interest expense.
The maximum loan payment supportable by a level of income for debt
coverage can be determined by dividing the income available for
debt coverage by the predetermined minimum debt coverage ratio.
For example, requiring a debt coverage ratio of 1.25 is equivalent
to stating that no more than 80 percent (1 / 1.25) of income available
for debt coverage can be allocated to payment of principal and interest.
Once a maximum loan payment has been established, the maximum amount
of debt that could be supported by income for debt coverage can
be determined for any given amortization schedule (interest rate
and loan term). Thus, applying a minimum debt coverage ratio requirement
to any farm operator, the maximum debt that can be repaid from any
level of income for debt coverage can be computed.
Debt repayment capacity utilization model calculations
(1) Income for Debt Coverage (Farm Operators) = Net farm income
+ Depreciation + Interest on capital debt + Capital lease payments
+ Net off-farm income - Living expenses - Income taxes
(1a) Income for Debt Coverage (Farm Businesses) = Net
farm income + Depreciation + Interest on capital debt + Capital
lease payments
(1b) Income for Debt Coverage (Farm Sector) = Net cash income
+ Interest on capital debt
(2) Debt Repayment = Principal and interest on capital debt
+ Capital lease payments
(3) Total Debt Coverage Ratio = Income for debt coverage / Debt
repayment
Should be no less than 1.25:1
(4) Maximum Loan Payment = Income for debt coverage / Minimum
debt coverage ratio
A debt coverage ratio of 1.25 is equivalent to stating that no
more than 80 percent (1 / 1.25) of income for debt coverage can
be allocated to principal and interest.
(5) Debt Repayment Capacity = Maximum loan payment x (1-(1+r)-n)/r
Where (1-(1+r)-n)/r = Present value of an annuity of
$1, at r percent for n periods
Individual debt repayment capacity was calculated at average interest
rates reported annually in ARMS, while farm sector debt repayment
capacity was calculated at average interest rates reported by banks
on nonreal estate loans. For individuals and the farm sector, loans
are amortized over a hypothetical repayment term of 7 years.
(6) Debt Repayment Capacity Utilization = Debt / Debt repayment
capacity
The ratio of actual debt to maximum debt repayment capacity
measures the extent of use of potential credit repayment ability.
(7) Maximum feasible debt / asset ratio = Debt repayment capacity
/ Assets
References Ryan, James T. and Mitchell Morehart. "Debt Repayment Capacity
of Commercial Farm Operators: How Much Debt Can Farmers Afford?"
Agricultural Income and Finance: Situation and Outlook Report. AFO-45.
Washington, D.C.: Economic Research Service (May 1992).
Farm Financial Standards Council (FFSC). Financial Guidelines for
Agricultural Producers: Recommendations of the Farm Financial Standards
Task Force. (Revised) July 1995.
Ryan, James T. "Utilization of Debt Repayment Capacity by Commercial
Farm Operators." Paper presented at AAEA annual meeting, Indianapolis,
IN, August 8, 1995.
U.S. Department of Agriculture (USDAa). Agricultural
Income and Finance: Situation and Outlook Report. Washington,
D.C.: Economic Research Service (Various issues).
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