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Borrowing in a Risky Environment

Make sure your loan documentation is complete, accurate and realistic.

Landscapes Summer 2009

Given the size and capital intensity of today’s commercial farms and ranches, it is virtually impossible to operate or grow the business without using credit. But the importance of risk management has made the process of acquiring credit more rigorous. The result is that agricultural firms will be treated more like other commercial businesses; lenders will take a more performance-based approach to lending; and producers will need to be better prepared.

The following questions can help you develop the documentation you need in a loan package.

How much money will you need? Not just initially, but over the period of the loan and for the purpose of the loan request. Lenders don’t want to lend all they feel comfortable with and learn later that more money is needed for the loan purpose. Your estimates of repayment ability should be realistic and conservative; cost estimates should address typical contingencies.

What will the money 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 debt and finance capital purchases. Support your plans not just with budgets but with historical documentation showing that the budgets reflect past experience. Projections should be based on realistic performance that is in line with past achievements.

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?

How will the loan be secured? Collateral is adequate only if, under the worst conditions, it could generate enough cash to repay the loan and cover all the costs involved. The primary purpose of collateral is to provide insurance in the event of default; therefore, the important lending consideration is the collateral’s expected value at the due date of the note or at the next scheduled payment.

How will the loan be repaid? Will it be repaid from operating profits, nonfarm income, the sale of the asset being financed, refinancing or the liquidation of other assets?

When will the money be needed, and when will it be repaid? This question should be answered by the projected cash-flow budget. Answering it will ensure that both you and the lender know how the business operates. Almost as many credit problems result from a lack of understanding and communication as from unrealistic expectations.

Are your projections reasonable and supported by documented historical information? Your production, marketing and financial records will demonstrate your track records and support your numbers. Many loans that probably could have been repaid were not made, simply because borrowers did not give their lenders complete and well-documented historical financial information.

How will alternative possible outcomes affect your repayment ability? Cash-flow projections often vary from the actual outcome, especially on the revenue side. Making sound projections and analyzing “what if” scenarios are particularly important considering the price and yield volatility in agriculture. Even when you have marketing and production contracts, quality discounts and premiums can cause uncertainty. But the most common error occurs when borrowers and lenders believe they are addressing the effect of standard scenarios, such as a 25 percent decrease in revenue. When considering alternate outcomes, take into account the business’s actual historical performance variability, as well as the range of current forecasts.

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. Every plan should have a backup plan, and every entry strategy should have an exit strategy, especially if niche markets are involved.

How much can you afford to lose, yet still maintain a viable operation? First, recognize that a viable net worth is not just anything above zero. Most commercial lenders require some minimum equity position, for example 30 percent, below which they will not continue financing without an external guarantee. Thus, the answer to the question must be based on the effect of potential operating losses and declines in asset values, and how likely it is that these situations will occur.

What risk management measures have been, or will be, implemented? This can cover anything from formal risk management tools to management strategies. Both the borrower and the lender must understand how these measures work, and the lender must be supportive and committed. For example, incorrect use of commodity futures can increase, rather than reduce, risk. A lender’s unwillingness to finance margin calls also can destroy a successful hedge.

What have been the trends in the business’s key financial position and performance indicators? First, do you know the trends? Second, if the trends are adverse, what are your specific short- and long-term plans for turning things around? As risk increases, your ability to take timely actions and manage problems is critical.

Finally, it is important to keep in mind when seeking credit that a lender’s request for more accurate and complete information should not be viewed as questioning your character; it is just good business.

– Danny Klinefelter

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