Being Prepared to Borrow

By: Danny Klinefelter

The size and capital intensity of today’s commercial farms and ranches make it virtually impossible to operate the business or to grow without using credit. But the current level of financial stress and the increasing emphasis on risk management is going to make the credit acquisition process more rigorous for agricultural producers.

This will mean a more performance based approach to borrowing. To help you be better prepared, the following twelve questions lay out a framework for developing the documentation needed in a loan package or business plan. The first six should really be no brainers; but, I never cease to be amazed by how superficially they are often addressed. Even if your lender doesn’t specifically ask them, they are questions a business oriented producer ought to be addressing from a risk management standpoint.

  1. How much money are you going to need? Not just initially, but over the period of and for the purpose of the loan request. Lenders don’t want to loan all they feel comfortable with and then suddenly find they need to loan significantly more in order to see the situation through to completion. Estimates of repayment ability need to be realistic and conservative, and cost estimates need to address typical contingencies.
  2. What is the money going to be used for? Be specific. It’s not enough to say “operating expenses.” In the past, too many operating loans have been used to subsidize lifestyles, refinance and/or pay carryover debt, and finance capital purchases. Plans need to be supported not just by budgets, but by documentation showing that they reflect past experience. Too many projections appear to be based on realistic estimates, but further review often shows they represent performance levels that are out of line with what the business has actually been able to achieve in the past. If you’re projecting improved performance, you need to be able to demonstrate both how and why.
  3. How will the loan affect your financial position? It is obviously important to know what your net worth, financial structure, historical cash flows, profitability and risk exposure are at the time of the loan request, but what will things look like after the loan is made? Will your risk profile in terms of working capital, leverage and debt repayment capacity change materially?
  4. How will the loan be secured? You need to recognize that collateral is adequate only if, under the worst conditions, enough could be collected to generate sufficient cash to repay the loan and cover all the costs involved. Except for control purposes, the primary purpose of collateral is to provide insurance in the event of default; therefore, the important lending consideration is not what it is worth at the time of the loan request, but what is its expected value at the due date of the note or at the date of the next scheduled payment. The lender needs to account for the period of time involved, potential changes in collateral value and condition, legal and selling costs, and the fact that a distress sale will bring less than an arms length transaction under normal market conditions. The changing nature of security has become one of the most significant factors affecting agricultural lending. More loans are now dependent on soft in addition to hard assets, i.e. key personnel, contracts and leases. There are also more joint ownership arrangements and market risks related to specific attribute raw materials rather than straight commodities. All of these make it more difficult for the lender to assess a net realizable value. For example, what’s an empty hog building or dairy facility really worth in today’s environment?
  5. How will the loan be repaid? Will it be from operating profits, from non-farm income, from the sale of the asset being financed, from refinancing or from the liquidation of other assets? How predictable and dependable is the source of repayment? 
  6. When will the money be needed and when will it be repaid? This two-part question should be answered by the projected cash flow budget. Answering this question makes sure both you and the lender know how the business operates. Almost as many credit problems have resulted from a lack of understanding and communication, as have resulted from unrealistic expectations. Marketing plans and trigger points, contract terms and conditions, and various pooling arrangements are often not adequately communicated or documented.
  7. Are your projections reasonable and supported by documented historical information? Too many producers still do not have the production, marketing and financial records to demonstrate their track record and support their numbers. Many loans have not been made that probably could have been repaid simply because of a borrower’s inability or unwillingness to provide the lender with complete and well documented historical information on his financial position and performance. It is extremely important that borrowers be objective in their cash flow projections, not just for the lender but also for their own management purposes. One study of farm borrowers over a period of several years found that, on average, they overestimated cash receipts by 15 percent and underestimated cash expenditures by 17 percent. If these errors were purely a function of market and production variability, revenues should have been underestimated as often as they were overestimated, and the same should have been true for expenditures. Unfortunately, there has been a tendency toward too much wishful thinking and a lack of adequate planning in the development of cash flow projections.
  8. How will alternative possible outcomes affect your repayment ability? Due to the numerous factors affecting production agriculture, cash flow projections frequently vary from the actual outcome. The importance of making sound projections and analyzing “what if” scenarios is even more important considering the increased volatility that producers have to deal with. Even under marketing and production contracts with established price bases, quality discounts and premiums can still result in a great deal of uncertainty. But, the most frequent error is one that occurs when borrowers and lenders actually believe they are addressing the issue. And that is when they evaluate the impact of standard scenarios such as a 10 or 25 percent decrease in revenues. For some businesses this practice overstates the risk involved, while for others it may seriously understate the potential risks. Done correctly, the alternatives considered should reflect the business’s actual historical performance variability as well as the range of current forecasts. While nearly all farmers and ranchers are on a cash basis for income tax purposes, most lenders will adjust this information for changes in inventories, accounts receivable, accounts payable and accrued expenses to get an estimate of income on an accrual basis. Many lenders are requiring borrowers to provide annual accrual basis income statements, and more will be. This is because while cash basis income accounting is valuable for income tax management, it is often a very inaccurate measure of business performance. Cash basis income can lag accrual income as much as 2 years in detecting upturns or downturns in profitability.
  9. How will you repay the loan if the first repayment plan fails? No commercial lender wants to enter into a situation in which foreclosure is the only alternative if things do not go as planned. Contingency planning is critical. Recognize what could go wrong and what you plan to do if it does. Every plan should have a backup plan and every entry strategy should have an exit strategy. This latter point is particularly true where 19 niche markets or new ventures/enterprises are involved.
  10. How much can you afford to lose and still maintain a viable operation? There are several factors to consider here. The first is to recognize that a viable net worth is not anything above zero. Most commercial lenders require some minimum equity position, e.g. 40 percent, below which they will not continue financing without an external guarantee. With this in mind, the answer to the question must be based on the effect of various combinations of both potential operating losses and declines in asset values. Lenders call this shock testing.
  11. What risk management measures have been or are to be implemented? This can cover anything from formal risk management tools to management strategies. The major issue here is to make absolutely sure that both the borrower and the lender understand how these measures work. For example, incorrect use of commodity futures and options can increase rather than reduce risk. It is also critical that the lender is supportive and committed. A lender’s unwillingness to finance margin calls can destroy a successful hedge.
  12. What have been the trends in the business’s key financial position and performance indicators? The first issue is do you know? The second is if the trends are adverse, what are the specific short-and longterm plans for turning things around? If they are to keep doing what you’ve been doing and hope things get better, you’re setting yourself up for a rejection. Timely action, willingness to change, and the ability to manage problems are hard to measure, but as risk increases they become critical in the credit decision process.

In conclusion, there are four important points for agricultural borrowers to keep in mind. First, a lender’s request for more accurate and complete information shouldn’t be viewed as questioning your character; it’s just good business. Second, any time new ownership/management of a lending institution occurs, tougher credit standards will almost always follow. Such changes usually do not indicate that the new management is too demanding, but that the former management was too lax, which frequently explains why there is new ownership/management. Third, many of the stricter credit standards being adopted can be directly attributed to legislation which provides for additional borrowers’ rights, increased food safety and environmental risks, and/or increased risks of lender liability lawsuits. Because litigation usually arises from situations in which borrowers are highly leveraged or in financial trouble, it has become more difficult for higher risk borrowers to qualify for credit. Just as malpractice lawsuits have changed the practice and raised the 20 cost of medicine, the threat of legal action has changed the lending environment. Finally, borrowers need to have the information required to negotiate terms or to find another lender if they have to. Becoming complacent just because your lender has never required all that has been mentioned above, could prove to be a poor risk management strategy if the management, ownership or underwriting standards of your lending institution suddenly changed.