What is the interest expense ratio?
For the purpose of this discussion, the interest expense ratio is calculated by dividing your business’s total interest expense on all loans for one fiscal or calendar year by the earnings before interest, income taxes, depreciation or amortization (commonly referred to as EBITDA). For example,
Total interest expenses $246,375 / $1,348,490 EBITDA
= 0.1827, for an interest expense ratio of 18.27%
If you look within the financial industry, there are other methods of calculating an interest expense ratio. One divides total business interest expenses by the total business expenses, while another method divides total business interest expense by revenue; yet another divides business revenue by the total business interest expense.
What is a good interest expense ratio target?
Based on the calculation laid out above, our recommended goal is to keep the interest expense ratio at or below 25 percent. The EBITDA value could also be defined as operating profit and is the only renewable source of cash that your business generates. If 25 percent of these funds is used to meet interest expense, this leaves 75 percent available for owner draws and taxes, term loan principal payments, and asset purchases.
In a balanced use of the 100% of the EBITDA funds available to a business,
- The interest expense ratio should be no more than 25 percent
- Owner draws should be 25 percent or less
- Term loan principal payments should be 25 percent or less
- The remaining 25 percent or more is available for asset purchases.
What if my interest expense ratio is higher than this?
Seldom will a farm operation use close to 25 percent of the EBITDA funds in each of these four categories to total the 100 percent available. For instance, it is not uncommon for a growing business to use a portion of the EBITDA funds plus additional borrowed funds (loans) to purchase assets that will generate additional revenues with the end goal of increased EBITDA funds. If interest expense uses more than 25 percent of the EBITDA, then
- The remaining three categories are limited to less than 75 percent of EBITDA.
- The operation may require a contribution from owners, additional borrowing rather than net repayment, or the sale rather than purchase of assets.
- This usually indicates that the business has too much debt. In this case, management needs to realize that risk to the business and take corrective action if necessary.
In some fiscal years, an operation may have large interest payments, which inflates the interest expense ratio. This may happen for an individual year, but a five-year analysis should show the interest expense ratio trending downward to 25 percent, or the five-year average should be close to 25 percent.
If future interest rate increases or higher loan amounts due to increased asset purchases will inflate your interest expense ratio considerably over 25 percent, you will want to consider how that reduces your ability to use your EBITDA funds for the other three purposes. Speak with your financial consultant, CPA, or accountant to plan out alternatives that keep the interest expense ratio at a level that does not place your business at risk.
If you need help understanding the financial considerations involved in knowing your interest expense ratio and level of EBITDA funds or believe your farm operation could benefit from agricultural financial consulting, contact the experts at UnCommon Farms.
