When you're sitting on a stash of cash, it's hard to be content to earn 1-3% interest on it in a checking account when you have loans that are costing maybe 8-11% or more. Should you pay ahead on the principal of loans when you have extra cash and cut your total interest cost?
"I hate to discourage anybody from pre-paying principal when their operation is profitable and they have some excess money available," says Bill Mayes, vice president of the Mercantile Bank of North Central Missouri at Shelbina. "But, I also like to see producers build some good liquidity in their operation so they have a reserve to let them sail right through market swings and price spikes that might go against them."
In the livestock industry, a pretty standard liquidity guideline is to have a current ratio of at least 1.5:1. Get your ratio by dividing your current assets (feed, livestock, cash on hand and anything else that you expect to sell or use within a year) by your current liabilities (debts that are due within one year, including the portion of long-term debt that is due within a year).
Mayes suggests that you may want to stretch that a little if you want to be even more sure you can weather market swings and price spikes. Then you might push that ratio closer to 2:1. In dollars, then, a good ratio might be $150-200 of current assets for each $100 of current debt.
"Where you keep your current ratio depends a lot on the operation and the overall debt and equity of the business," says Mayes. If you're highly leveraged, for example, getting into a squeeze on current debt could mean real debt trouble.
If you don't have a lot of other debt, of course, you have plenty of equity in your assets to hold you up. You can probably borrow against them for cash flow and to pay current debt if you have to. Then, a narrower current-asset to current-debt ratio isn't as dangerous.
Faster Debt Repayment If profit and cash flow are good enough to pay more toward principal, you can cut your interest cost dramatically.
Take, for example, a $500,000 loan at 9% with payments to be made over 10 years. Your annual payment will be about $77,910. Over the 10 years, you will pay back $779,100 ($77,910 x 10).
But what if you have profits and cash flow to pay $90,000 a year - an extra $12,090?
You could then pay the loan off in 8.043 years. Your total payments would be $723,870 ($90,000 x 8.043). You would pay about $55,230 less interest.
Table 1 (page 90) shows the dollars of annual payment required for each $1,000 borrowed at different interest rates and lengths of repayment.
Say, for instance, you plan to borrow $100,000 at 9% interest and want to pay it back over 10 years. Your annual payment would be about $15,582 ($155.82 x 10 years). If you could increase the payments to $19,869, you would pay the loan off in seven years.
(Bob Dunaway is an estate and financial planner and freelance business writer from Monroe, IA.)