The Highs and Lows of Financial Leverage

We have all heard our parents and grandparents say that they never purchased anything without having cash. Well, those views came from the time of the Great Depression where many a fortune was lost because of indebtedness.

In today’s agriculture industry, it is very difficult to get started or grow a business without utilizing debt. The question follows, how much is too much debt? What are the telltale signs of when you are in over your head?

Let’s look at banks themselves. A typical community bank will have a 10:1 return on equity ratio, i.e., $10 of borrowing for every $1 in equity capital. In the recent financial crisis, Lehman Brothers was 40:1, Fannie Mae and Freddie Mac were 80:1 and the banks “too big to fail” were 100:1. They had essentially no equity or reserve for the downturn, while being quite profitable in the positive side of the business cycle.

Homeowners are another example. Many consumers had a 125% debt to asset ratio, i.e. $1.25 of debt for every $1 of assets, and were borrowing to buy homes in states like Florida, Nevada and Arizona. This was a train wreck waiting to happen. Any change in the economic weather front would place these homeowners in dire straits, and unfortunately the economic change was severe.

Agriculture has its challenges, as well. Two areas appear to have many challenges: Producers who are aggressively growing their operations – particularly in the livestock sector – and land in transition for development or sale. Producers and investors in these situations that became highly leveraged and in many cases very profitable, suffered immensely when the global banking system collapsed and the economic recession occurred.

Lessons Learned

• Leverage without financial liquidity, i.e. working capital, is risky. If the debt to asset ratio is 60% or above, working capital to revenue needs to be above 33% and two to three months worth of expenses in cash on hand is recommended.
• A sound risk-management plan, including input cost and interest rate strategy, as well as options and/or hedging contracts, is essential.
• Third, if you operate a large complex business borrowing money, will you become too big to finance or too big to sell if an exit strategy is desired?

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.