Years ago, when I was a young commercial lender, still wet behind the ears, I learned how to judge if a borrower has the ability to repay the loan. This was by using the debt service coverage ratio (DSCR) calculation. Basically, this takes gross income and deducts all operating expenses to reach a net operating income line. This amount is divided by the annual debt service requirements to get a ratio. If the ratio is at 1:1 then the business just makes enough money to pay all operating expenses and debt payments but has nothing else left over for owner payments or capital improvements.
Once I learned this, I thought I had found the holy grail of lending!
But just like the cave began to crumble around Indiana Jones when he picked up the sacred cup, I soon found times when my analysis would crumble around me if I was to base my review upon the DSCR. One area where this really comes to light is with agricultural lending, especially when the producer is providing cash-based income statements.
Consider the issues of the timing of when crop is raised compared to when it is sold and when cash is received. I once had a potato farmer who showed massive cash losses in his tax return. This was enough to raise the hair on the back of your neck, until I learned that a large payment for that year’s crop by Frito-Lay was not received until the following year. When the financials were adjusted from a cash to an accrual basis, they easily met our DSCR standard.
Another issue is when a rancher increases his cash income by selling breeding stock. One cow-calf operator usually ran 100 heifers as breeding stock. One year we saw a spike in cash income which looked great until we discovered that they now had only 59 heifers instead of the usual 100. Now their ability to keep production at previous year’s levels was in question.
Other factors are when expenses are prepaid for future years or may be incurred but not paid until another period. This also must be watched for supplies and inventory levels. Any expansion or contraction on these away from previous year’s levels may skew the cash, based borrower’s income statement, and thus your analysis.
This is one of the topics that we will be covering in our upcoming class on September 19-20 in Bismarck. Sign up today as our class is filling up fast!