Continued from last month: Manageable debt levels. A discussion of cash flow leads to comments about debt.
Although debt is a normal part of business, the ability to maintain a low debt level is one of the best ways to weather bad operational years.
High debt levels reduce the capacity of a business to make choices, and leave it vulnerable to bank tensions during a tough year.
Attitude to debt
Attitude to debt is a personal thing. Some business owners don’t like debt; others don’t worry about high debt that much if they are confident about generating good cash flows.
In the latter case, they will drive business expansion through debt and work hard to ensure that borrowings are repaid when due.
I am in the conservative camp on debt on the basis that a business may need the capacity to ride out two poor years or more in a row, and there must be fat in the system to ensure that can happen.
My view is coloured by seeing too many businesses struggle with high debt.
I have also worked with one business whose owners hate debt. Some years ago, their debt was significant and they decided to concentrate on reducing that without damaging business growth (this requires profitable years and strict control on capital outgoings). They now have a very low debt level and pay for a proportion of new assets from operating cash flow.
Equity Ratio
Whether or not you like debt, there are some objective rules of thumb about an appropriate level of debt, and this is measured by the Equity Ratio.
Most businesses will have completed a Statement of Position for their bank. This one-page document lists the assets (at market value) and liabilities of the business and it should be updated each year-end.
To determine your Equity Ratio, deduct the value of Total Liabilities from the value of Total Assets, and divide that figure (called Net Assets) by the value of Total Assets. The resulting figures, expressed as a percentage, is your Equity Ratio.
If in doubt, your bank manager will have equity ratio figures to hand and would be pleased to discuss these with you.
Although average agricultural debt for most farm types has increased in recent years, strong, low-debt businesses will typically have an Equity Ratio of 75–80%, that is, the owners own 80% of the business.
Orchard ratios are usually lower than this, but should preferably be no less than about 65%.
An Equity Ratio approaching 50% signifies a business that will normally struggle during poor trading years.
Conclusion
A good profit history; strong cash flow; and a sound debt position—three simple measures of a healthy business which, if in good shape, mean that an owner can sleep well at night.
However, the current business environment is not easy, and it can be difficult to achieve these indicators.
Whether business life is tough or not, you owe it to yourself as a business owner to have a good understanding of these indicators, and make objective decisions based on that knowledge.
If you don’t fully appreciate what they are or mean, your accountant and bank manager would be pleased to help you.
See this article in Tree Fruit August 2013
