Anyone in the protein or livestock industry knows the downside of high amounts of financial leverage. When the debt-to-asset ratio exceeds 50%, percent equity is below 50% and debt-to-equity level exceeds a ratio of 1:1, it places your business in big league financial operations. When reduced output prices and higher input costs occur, it places your business in late stages of the game, being significantly down on the scorecard.
My good friend, Ed LaDue of Cornell University, a retired agricultural finance professor, conducted a study of the 1980s farm crisis and discovered financial leverage was the No.1 predictor of business failure during that period. This is due in part to the fact that heavy financial obligations result in high debt service, i.e. principal and interest payments. These payments are considered a fixed expense or cost regardless of the economic environment. Reduced prices and higher input costs squeeze the margins needed to repay the financial obligations.
A high amount of financial leverage also reduces flexibility, stifling the ability to adapt or change management practices to improve the bottom line. Competitiveness of highly leveraged businesses is also hindered when compared to those with little or no debt because of the extra interest and principal cost.
Debt becomes a bigger burden particularly in economic cycles with deflationary revenue and assets values because fewer dollars are available to pay a fixed cost obligation.
Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at sullylab@vt.edu.