Credit Analysis - Associated Farm Mortgage - Real Estate Lenders for Agriculture

Agriculture has its own inherit risks and unique characteristics. As a result, agricultural credit is different than normal consumer credit. We provide the following to aid farmers and ranchers in understanding and maintaining their credit.

What is it that agricultural lenders look for, why, and what can you do to improve your standing with lenders? Due to the nature of agriculture, the following guidelines are for Ag borrowers, and due to the complexity of agriculture some of the suggestions may not apply to your situation.

We provide this resource with the following disclosure: We provide no guarantee that following these suggestions will assure that you are successful, as always you should seek qualified third party assistance in planning.

Risk is any lenders primary concern. Simply put, lenders determine what the chances are that you will have late payments, and/or they will be required to liquidate collateral to collect payment, and/or they will loose some portion of the loan. All quality lenders want to make loans, but only those loans that provide assurance of timely repayment.

What do we look at to determine risk?

The first thing is history – lenders believe that history is the window that allows us to see into the future. For this reason it is critically important that you manage your operation very carefully. All good ag lenders understand you will have bad years – beyond your management ability, what we look for are trends and what, if any, steps you took to mitigate losses. One bad year will not normally kill your future, but several back-to-back years can.

Accurate, complete, detailed, realistic financial statements are the first item. Financial statements tell us where you have been, where you are, and offer a small glimpse of how you got there. The next item is accurate profit & loss statements. Normally these are provided in the form of Federal Income Tax Returns. For larger and/or more complex operations, both cash and accrual Profit and Loss statements, along with production records are important additions that most lenders like to see.

A positive cash flow is the most important item for timely debt repayment. A positive cash flow is defined as cash after payment of all expenses including taxes, living expenses, and all note payments.

Lenders understand depreciation, we know in most cases it is a real expense item. Rarely do equipment and other depreciable items increase in value as you use them – normally they wear out and must be replaced. If you don’t reduce the loan balance as the item depreciates, when it is worn out you will have little to no equity, and replacing the item will be difficult.

When we examine all this financial data – what is it that we are looking for?

There are four factors that lenders look at to determine credit; character, capital, capacity, and collateral.

Character -
Management is a reflection of character.

Does the history of your operation (including use of consumer credit) indicate good planning and discipline? If so, most lenders will conclude that you have excellent character. When lenders see historical indications of problems, we question the management ability of the operator. Some problems are unavoidable and explainable, such as extended drought or hail damage, but repeated non-payment of debts is normally an indication of poor planning and/or lack of discipline regarding credit availability. Poor management equals poor character.
Capital -
Capital is examined from two perspectives, working capital and equity capital.
- Working capital is determined by examining current assets and current liabilities; it tells lenders what your immediate repayment ability looks like. You need to have sufficient current assets to pay all your current liabilities with some reasonable margin of safety. It is impossible to utilize short-term loans (line of credit) to improve your working capital. True, a line of credit will provide necessary availability of cash, but remember that lines of credit are normally due at the end of the production cycle. Consequently, all you have done is increased both current assets and current liabilities.
- Equity capital is your net worth; it reflects your historical management of assets. Equity capital is also the most critical item needed to weather financial storms. Good AG lenders know that bad years will occur, and the question is not if, but when they will occur. Your equity allows your lender the opportunity to see you through the problem. Without equity capital, when that bad year comes along, your lender will have no choice but to liquidate collateral. Net worth or equity capital is also examined from the perspective of what is earned and what occurred from appreciation of real property.
Capacity -
Capacity is your ability to service your debt, and is also known as net available cash flow.

Some borrowers are shocked to find they are denied because they don’t have sufficient cash flow to service their debt, and can’t understand why, because they have been making all their payments! How can this be? Historical repayment without sustainable cash flow can occur from two different sources;

increased borrowing, and/or

liquidation of assets.

It is necessary when you have a bad year to increase your borrowing – we all understand that. It may be wise to liquidate some assets from time to time – that to is well understood. However, in order to sustain operations AND provide timely repayment, your overall operation must generate sufficient excess cash (over and above expenses) to adequately support all debt payments. The source of this cash needs to be from the operation, not from borrowings or the sale of assets.

Collateral -
- Collateral is what you provide as security to the lender.
- By providing collateral you say to the lender, if this doesn’t work and I fail to make my payments, I will lose ownership of this item. Collateral provides for the shared risk concept - the lender puts up the money and you put up the collateral. Prudent lenders ask that you have some reasonable ownership in the collateral, meaning they will not finance 100%. If they do, you have no risk and nothing to loose if you miss payments. As a general rule, you should NEVER borrow 100%, and a good lender will never loan 100%. How much equity should you have? This depends on the asset, but a general rule is not less than 30-35% of its value.
- Lenders want collateral for two reasons; the first is control (so you don’t incur additional debt). The second is that collateral provides the last source of repayment.

Credit underwriting is a judgment call utilizing all of the above. Good lenders will not provide credit based on the strength of a single item, but may very well deny credit based on the weakness of a single item. As an example, our largest single reason for denial is lack of collateral equity, meaning people want to borrow too high a percentage of the value of the asset provided for security.

A final note on Risk: when or if you find a lender who is willing to advance funds when the risk is above acceptable levels – most often you have found a lender who

These lenders are normally referred to as “hard money lenders”, they provide funds with little to no consideration of your future, but they fully understand the concept of collateral. While most good lenders view collateral as the last source of repayment, these lenders view collateral liquidation as the first source of repayment. To accept a loan under these circumstances gambles your collateral against your chances of future success, all while minimizing its probability due to excessive interest and related costs.

The above is a general overview of how credit works. What follows is some detail regarding the various factors indicated above.

Record Keeping

In order to provide what you need for decision making and what your lender will look for to approve your loan request, accurate and timely records are a must. In today’s age of computers there are few excuses left for not having complete, accurate, and timely records. INTERNAL RECORDS ARE CRITICAL! If your idea of record keeping is to take 12 bank statements to your accountant at the end of the year and say “Do my taxes,” then you need to improve your internal record keeping.

Internal record keeping must include all of the following:

Accurate, detailed and individual listings of all assets, including: date purchased, make and model, cost, serial number or other description, expected useful life, and if pledged as security – who is the creditor.
Accurate, up to date listing of all creditors, with balance outstanding, repayment terms, collateral, loan officer and complete contact information
Balanced checking account, one that you know exactly how much money is in the bank, what checks have cleared, what checks are outstanding, etc. If you must access the bank via ATM and/or the Internet to find out your account balance, then your record keeping could use some serious improvement.
Accurate and detailed record of all income and expenses. This must be broken down by the various categories in such a fashion that you can rapidly determine what you made from all the various sources, and what you have spent on all the various expense categories.
Accurate and detailed records of all Accounts Receivable. When you sell something, until you have collected the money, it really doesn’t do you a lot of good. You must know exactly WHO purchased WHAT, WHEN, and what the terms of repayment are. It is advisable to always get invoices SIGNED! When you have Accounts Receivable, you are lending your money to the individual - it might be wise to evaluate the risk.
Accurate and detailed listing of all Accounts Payable. This needs to include what the terms of repayment are.
Production records. You need to know (and almost all operating lenders will ask) what you produced. This needs to include the number of acres, trees, cows etc as applicable for your operation.

There are a number of good record keeping programs available for your PC. Classes are available at many local community colleges, and your tax accountant can make recommendations on how to keep accurate records. Use whatever means are necessary to ensure you have timely and accurate records.

For many small to medium sized operations, good checkbook programs like Quicken or QuickBooks, along with a spreadsheet program such as Excel will provide all the tools you need. For larger and more complex operations, integrated software designed for your particular agricultural enterprise is available and should be considered.

Last, be sure you utilize the services of a good, reputable, knowledgeable accountant for tax preparation. Given the complexity of today's tax laws, doing taxes by hand is like performing brain surgery on yourself. However, do NOT make purchase decisions based solely on the accountants advice that doing so will avoiding paying a few dollars of taxes by gaining the depreciation. It may be better to pay a few thousand in taxes than to have to debt service the purchase to the tune of tens of thousand for several years.

Consumer Credit

The easy availability of consumer credit is a leading cause of problems with many agriculture producers. Just because a credit card company will say yes and give you a $25,000 line doesn’t mean you should immediately take a trip to Vegas and run the card up. Don’t utilize your credit cards for operating costs just because it’s so easy. The interest costs are too excessive, and thereafter, all operating lenders will be very suspect of your prior practice. Do NOT use one card to pay another card; this is a game that will ruin your credit.

If you are taking more than 90 days to pay off your credit cards (from the date of the advance to the date that advance is totally paid off), then you may want to examine your credit spending habits. If you are past due with consumer credit, the first step in finding your way out of this trap is to throw away the shovel you are using to dig your financial grave with. The next step after you stop charging is to pay more than the minimum balance. There are a number of consumer credit counseling services available, but avoid those who are going to compromise your debt. This will almost always end up with larger problems than you started with.

What follows is a brief definition of how consumer credit histories (credit reports) are viewed by most lenders:

Excellent, Good, and Average credit history can expect to receive financing, assuming there are no other weaknesses or problems. Regardless of the collateral, if you have poor and/or adverse consumer credit history, you should not expect to receive credit under normal circumstances and terms.

How to determine Historical Cash Flow

This is a primary planning tool, and will aid you in purchase or lease decisions. Generating sufficient cash from sustainable operations to make your payments is the only acceptable long-term method of operating. What follows is how annual cash flow is determined.

Add ALL of the following items:

Gross wages if any,
Interest Income,
Other non-business revenue,
NET Schedule C earnings (or subtract net loss),
NET Schedule E earnings (or subtract net loss),
NET Schedule F (Farm) earnings (or subtract net loss),
- All of the above is normally totaled on your tax return as “total income” on row 22 of your tax return (watch out for capital gains – these should not normally be included as they are not reoccurring).
Depreciation expense from Schedules C, E, & F,
Interest expense from Schedules C, E, & F,
Capital Lease payments.

From the above subtotal, SUBTRACT all of the following:

Income taxes, including self-employment, and state taxes if applicable,
Family living expenses (without any debt payment)

What you have left is gross cash available to service debt; this amount needs to be greater than the total of all debt payments (including capital lease payments) for the year. If you have lines of credit, only consider their interest expense in the debt repayment total. The greater the margin, the better; most lenders want to see 120-135% “coverage”, meaning for each dollar of debt payment due annually, you will have from $1.20 to $1.35 in cash available.

The smaller this margin, the greater the risk. Remember that history is the window of the future. If your operation is static in size and this margin is less than 115%, you must be very careful about any additional debt. If the margin is consistently below 100%, you are headed for a disaster once your lender catches up to the information curve.

Bad years – what to do?

We know you will have them, and most often your lender will know ahead of time when weather and/or market prices implement the bad year.

The first thing is to make sure you have ALL the information; current, accurate, realistic financial statement, production records, and a profit and loss report (don’t wait for the tax return). Next, communicate openly with ALL your creditors. Don’t wait until the payment is due to start the communication!

Find out if you can utilize current equity in various assets to borrow additional funds (and still be able to meet all the repayment tests – this is the reason lenders typically look for some repayment margin). If weather has created the problem, look for emergency or disaster loans, sometimes available through the local Farm Service Agency (an agency of USDA). Check to see if you have assets that are not required for your operation, sell these and utilize the equity to repay short-term creditors. Last, cut expenses, postpone expansion, defer purchases, limit personal withdrawals (go on a budget). Do all those things that will improve your cash situation. Cash is KING!!!

We hope all this provides you with some insight into how agriculture credit analysis works. We look forward to providing you with your next AG mortgage.

Agricultural Credit