Department of Rural Economy, 515 General Services Building,
University of Alberta, Edmonton, AB, T6G 2H1, Canada
Email: fnovak@re.ualberta.ca
Take Home Message
Introduction
A common theme across livestock sectors in Western Canada these days is expansion. The hog industry appears to be entering a phase of industry expansion, increasing total production and average farm size. Dairy and beef sectors are seeing greater expansion in terms of farm size rather than total industry output.
Expansion will require significant capital expenditures. Typical investment levels for Alberta dairy operations exceed $7000 per cow, excluding the value of quota which might represent another $7400 of investment (AAFRD, 1996). Doubling a 70+ animal operation could involve a total investment in excess of one million dollars. Depending on current financial structure, this expansion would likely involve a significant amount of debt financing.
An obvious point is that the investor/manager needs to be fully aware of the relationship between financing decisions, profitability, and risk. Increased use of debt capital and unpredictable changes in government support programs makes it more difficult for managers to determine the best combinations of financial structure and business practices. Understanding these relationships is critical to ensure long term prosperity and avoid the financial disasters of the past.
In this paper, we briefly review the concept of leverage and its effects on profit and risk. The concepts of business risk and financial risk are introduced and used to illustrate the interactions between leverage decisions and financial well-being in the context of an expansion decision.
The Concept of Leverage
Expansion capital comes in only two forms, debt and equity. Debt capital is appealing because it is cheaper and likely easier to obtain than equity. The degree of debt financing used can be described using the concept of leverage (Debt/Equity Ratio).
A useful approach to discussing the effects of debt choices on an operation is through the standard return on investment calculations. The profits of a business represent a rate of return to the capital invested in that business. The return to total invested capital is usually described as the Return on Assets (ROA). This is what the business entity earns. We are often concerned with what the owners of the business earn. Typically there are two "owners" namely the holders of the debt and equity capital which make up the financing package. The returns to the business entity are shared between these owners. As a rule the debt holders get paid first which means equity holders are residual claimants to any profits. As such, the equity owners absorb all of the variability in earnings.
The relationship between return on assets, leverage, and return on equity can be described using the following equation.
ROE = ROA + Leverage (ROA - INT)
where ROE is percent return on equity, ROA is percent return on assets, leverage is the ratio of debt to equity, and INT is the cost of debt in percent. This definition will produce a measure of equity change which should match the calculation made on a standard set of financial statements. This number will not match the return on equity found in cost of production publications which make arbitrary allocations to management.
A great part of the appeal of leverage is due to the fact that it can enhance returns to equity holders (Figure 1). As long as the business entity generates returns which exceed the cost of debt capital, leverages works in a positive manner. The downside of debt occurs when we consider risk. Variability in returns and asset value changes are accentuated by leverage.
Consider the simple example of a drop in asset values. In our case this might happen from a loss of quota value due to some unexpected trade ruling. An example from the 1994 COP Study identified quota values equal to 34% of total assets. Consider a drop in quota value equal to about one third of this total; equal to approximately a 10% drop in asset values. Table 1 outlines the effect of this event on the resulting equity level given different levels of debt. A relatively innocuous drop in asset value can actually translate into a significant equity loss.
Figure 1. Leverage and rate of return variability.
Table 1. Impact of asset value changes on equity.
| Assets | 100,000 | 100,000 | 100,000 | 100,000 |
| Debt | 0 | 20,000 | 50,000 | 75,000 |
| Equity | 100,000 | 80,000 | 50,000 | 25,000 |
| Leverage | 0 | 0.25 | 1 | 3 |
| Drop in Asset Value | 10,000 | 10,000 | 10,000 | 10,000 |
| % Drop in Value | 10 | 10 | 10 | 10 |
| Resulting Asset Value | 90,000 | 90,000 | 90,000 | 90,000 |
| Resulting Leverage | 0 | 0.29 | 1.25 | 5 |
| % Drop in Equity | 10 | 13 | 20 | 40 |
The Concepts of Business Risk and Financial Risk
Up to this point we have basically ignored the reality of variable cash flows. Business Risk arises from variability in a firm's production and marketing efforts.
Table 2 provides a simple comparison of business risk from different agricultural and financial enterprises measured using return on assets. The cattle, hog, and stock returns are based on research at the University of Alberta and the dairy returns were adapted from Cost of Production studies. Relative variability in returns can be measured using the coefficient of variation statistic. One striking result of this comparison is relatively low level of business risk in the dairy sector.(1)
Our purpose today is to use that data to look at the effects of financing decisions on farm business.
Table 2. Mean and standard deviation of real return on assets for select agricultural enterprises (1980-1995) and financial markets.
| Enterprise | Mean | Standard Deviation | Coefficient of Variation |
| TSE300 | 9 | 19 | 2.11 |
| Dairy | 12.5 | 5.0 | 0.40 |
| Hogs | 33 | 54 | 1.64 |
| Cattle Finishing | 16.6 | 29.52 | 1.78 |
The variability in cash flows from business operations is enhanced by the use of leverage. The risk enhancing effect of debt is known as financial risk. As we described earlier, debt increases variability in returns to equity holders because it represents a prior claim on working capital. Business owners are the residual claimants who absorb this variability.
The manager's decision becomes an analysis of the tradeoff between the return enhancing effects of leverage and increases in financial risk. The tradeoff can be illustrated by looking at our measures of relative variability as the degree of leverage increases. Table 3 outlines this issue using our hypothetical dairy returns data. The coefficient of variation now measures what we call total risk, the variability in return on equity. The degree to which this figure differs from the variability of returns on assets is due to financial risk. For example, with no debt the C.V. on equity is the same as on assets, 0.40 and there is no financial risk. At a leverage of 1.0 the C.V. climbs to .59 which is 1.475 times greater than the risk without leverage. The financial risk in this case is 1.475.
Table 3. Changes in relative variability of return on equity for different leverage levels using dairy return data.
| ROA | ROE | Standard Deviation | Coefficient of Variation | |
| Leverage = 0.0 | 12.5 | 12.50 | 5.0 | .40 |
| Leverage = 0.5 | 12.5 | 14.75 | 7.5 | .51 |
| Leverage = 1.0 | 12.5 | 17.00 | 10.0 | .59 |
| Leverage = 1.5 | 12.5 | 19.25 | 12.5 | .65 |
| Leverage = 2.0 | 12.5 | 21.51 | 15.0 | .70 |
| Leverage = 4.0 | 12.5 | 30.50 | 25.0 | .82 |
Note: Average Leverage in 1995 COP Study was .52 and maximum leverage ratio on non-quota purchases is about 4.0 (80% financing).
The use of increasing amounts of debt capital can significantly increase the relative variability of returns to equity owners. As the table above illustrates, relative risk at a leverage ratio of 2 is about 1.7 times greater than risk without debt. This increases to a factor greater than two when we look at the maximum possible level of debt. Again, this increase in risk results purely from the financing decision and has nothing to do with changes in operations.
A second way to look at the effects of financing is to measure the probability of a business failing to achieve some target level of return. Two important targets are a zero return or the return required to make debt payments. Using our numbers from above it is possible to calculate the probabilities of negative return on equity for different debt levels (Table 4). Increasing leverage from 0 to 1.0 results in a 7 fold increase in the probability of negative returns. This jumps to 12 and 180 times for leverage ratios of 2 and 4 respectively. The relative increases in downside risk illustrated below are inflated somewhat by the low base probabilities. Our purpose here is only to illustrate the principals at work.
Table 4. Probability of negative return on equity for different leverage ratios.
| Leverage | 0.0 | 0.50 | 1.0 | 1.5 | 2.0 | 4.0 |
| Probability | 0.0062 | 0.0246 | 0.0446 | 0.0618 | 0.076 | 0.112 |
The Expansion Decision Illustrated
Among the factors driving expansion decisions are the desire to capture the economies of size which may result. For an individual producer the decision involves a tradeoff between improved efficiencies and, hopefully, profitability associated with the larger operation vs. the increased financial risk which results from the use of debt to finance the expansion.
This tradeoff can be evaluated by using the concepts identified above. Our sample producer currently has a 72 cow herd with a return on assets of 12.5 %. The current leverage ratio is 0.50. Expansion to 150 cows will require an investment of $1,123,200. Lets assume that expansion is financed with enough debt capital to result in a modest jump in leverage to 1.0. The financial risk associated with the increase in debt doubles the probability of a negative return on equity (see table above). This expansion would have to increase efficiencies enough to improve the rate of return to 14% in order to maintain the original probability of a negative return. Part of the manager's decision then is to assess the likelihood of these different outcomes.
Conclusions
In this paper we have attempted to introduce and illustrate the concepts of business and financial risk. These simple ideas provide a useful vehicle for understanding some important business relationships. By identifying how some important sources of risk interrelate we can gain a fuller understanding of the consequences of different management decisions.
The issue of expansion is before most agricultural producers today. Expansion related decisions are likely to increase in importance rather than decrease. Our simple take home message is that we need a healthy and informed respect for the role of debt in those decisions. We end by repeating the key points we began with.
1. 