university of houston-victoria small business development center pat calhoun - instructor

FARM LOANS FOR FARM LOANS FOR DUMMIESDUMMIES

Last year we taught you how Last year we taught you how to read ‘em, this year will to read ‘em, this year will

teach you how to build ‘em!teach you how to build ‘em!

University of Houston-Victoria

Small Business Development Center

Pat Calhoun - Instructor

OBJECTIVESOBJECTIVES to understand the impact of agriculture on the U.S.

economy

to learn agricultural terminology

to understand cash flow and production cycles

to understand the financial mindset of the average producer

to review benchmark ratios and their calculations

to learn common FSA forms

case study

ECONOMICAL FOOD ECONOMICAL FOOD SUPPLYSUPPLY

It takes about 40 days of income for most Americans to pay their annual food budget

It takes more than 100 days to pay their annual taxes

MOST AFFORDABLEMOST AFFORDABLE

AMERICAN FARMER AMERICAN FARMER IS:IS:

1997 – 32% age 65+ 1987 – 20% age 65+ 1978 – 15% age 65+

165,102 farms operated by women

Median age of all women on farms is 53.

U.S. FARM U.S. FARM LANDSCAPELANDSCAPE

Texas – 227,000 farms Missouri – 108,000 farms Iowa – 93,000 farms Tennessee – 91,000 farms California and Kentucky – 88,000 farms

U.S. FARM U.S. FARM LANDSCAPE con’t.LANDSCAPE con’t.

Individual or family owned – 86% Family partnership – 9% Family-owned corporation – 4% Non-family corporations – 1%

U.S. FARM U.S. FARM LANDSCAPE con’t.LANDSCAPE con’t.

Total land in farms was estimated 941.2 million acres in 2001 compared to 1.04 billion acres used for farming in 1980.

More than 24 million workers (17% of total U.S. workforce) produce, process, and sell the nation’s food and fiber.

U.S. FARM U.S. FARM LANDSCAPE con’t.LANDSCAPE con’t.

Small farms:

annual sales < $100K– 84% of all farms

– 35% of farm debt

– 13% of total farm sales

U.S. FARM U.S. FARM LANDSCAPE con’t.LANDSCAPE con’t.Commercial farms:

annual sales > $100K

– 16% of all farms

– 65% of farm debt

– 87% of total farm sales

PRODUCTIONPRODUCTIONToday’s farmer produces enough

food and fiber for 129 people.

PRODUCTIONPRODUCTIONToday’s farmer produces enough

food and fiber for 129 people.

ENVIRONMENTAL ENVIRONMENTAL PROTECTIONPROTECTION

Erosion rate by water on cropland has been reduced by 32% since 1982.

FOOD DOLLARFOOD DOLLAR

Farmers and Ranchers receive only 19¢ out of every dollar that is spent on food.

In 1980 farmers received 31¢.

AGRICULTURAL AGRICULTURAL TRADETRADE

InIn 20012001Total U.S. Agricultural exports = $53 billionTotal U.S. Agricultural exports = $53 billionTotal U.S. Agricultural imports = $39 billionTotal U.S. Agricultural imports = $39 billion

MORE THAN FOODMORE THAN FOODEthanol

1.77 billion gals. produced in 2001

655 mil. bu. of corn and 33 mil. bu. of grain sorghum used

61 ethanol plants in operation with 50 new plants scheduled to be on line by 2004

BiodieselFrom Jan 1999 to Sep 2001, more than 100 major vehicle fleets implemented biodiesel programs. i.e.

U.S. Army State of New Jersey Cincinnati city buses Florida Power and

Light

AGRICULTURAL AGRICULTURAL TERMINOLOGY AND TERMINOLOGY AND

PRODUCTION / PRODUCTION / CASHFLOW CYCLESCASHFLOW CYCLES

AGRICULTURAL AGRICULTURAL DEFINITIONSDEFINITIONS

Acre - It was in use in England at least as early as the eighth century, and by the end of the ninth century it was generally understood to be the area of a field one furlong (40 rods or 10 chains) long by 4 rods (or 1 chain) wide. Thus an acre is 10 square chains, 160 square rods, 43 560 square feet or 4840 square yards.

Furlong - The word "furlong", from the Old English fuhrlang, means "the length of a furrow"; it represents the distance a team of oxen could plow without needing a rest. A furlong equals 40 rods, which is exactly 10 chains, 220 yards, 660 feet, or 1/8 mile.

AGRICULTURAL AGRICULTURAL DEFINITIONSDEFINITIONS

Chain - a unit of distance formerly used by surveyors. The traditional British surveyor's chain, also called Gunter's chain because it was introduced by the English mathematician Edmund Gunter (1581-1626) in 1620, is 4 rods long: that's equal to exactly 1/10 furlong, 22 yards, or 66 feet (20.1168 meters).

Rod - a traditional unit of distance equal to 5.5 yards (16 feet 6 inches or exactly 5.0292 meters). The rod and the furlong were the basic distance units used by the Anglo-Saxon residents of England before the Norman

Conquest of 1066.

AGRICULTURAL AGRICULTURAL DEFINITIONSDEFINITIONS

Bushel - a commercial unit of weight for grains and other bulk commodities. Agricultural commodities such as wheat are traditionally sold by the bushel, but because commodities tend to settle and compact in shipping, disputes over the volume delivered arise easily. To avoid these disputes, traders in a market or a country generally agree on a standard weight for one bushel of the commodity. Often this standard weight is set by law. Although the bill of lading still shows "bushels," it is really the weight rather than the volume that is sold and guaranteed. For example, in the United States a bushel of wheat equals 60 pounds (27.216 kg), a bushel of barley 48 pounds (21.772 kg), a bushel of oats 32 pounds (14.515 kg), and a bushel of rye 56 pounds (25.401 kg).

AGRICULTURAL AGRICULTURAL DEFINITIONSDEFINITIONS

Hundredweight (cwt) - a traditional unit of weight equal to 1/20 ton. The U.S. hundredweight seems to have been invented by merchants around 1840. To distinguish the two hundredweight units, the British version is often called the long hundredweight (112 lbs.) and the American is called the short hundredweight (100 lbs.)

Barrel (bbl) - a commercial unit of weight, varying with the commodity being measured.

AVG. BU. WTS. AND AVG. BU. WTS. AND SEEDS / LB.SEEDS / LB.

HYBRID MATURITYHYBRID MATURITYMost crops mature enough to harvest in 120 to 180 days. This is not an exact figure, because growth rates are based on “heat units”. For example corn will not grow when the temperature is below 50° F and will not mature any faster once temperatures are higher than 86° F. Once they have accumulated enough heat units, then they are considered mature.

GESTATION PERIODSGESTATION PERIODS

Cow – 285 days Horse – 337 days Sheep – 148 days Goat – 151 days Pig – 113 days

CASHFLOW CASHFLOW CONSEQUENCESCONSEQUENCES

At best an agricultural producer will only have positive cash flow anywhere from one to three times in a year.

Counselor thinking has to adjust to the differences in the timing of cash flows.

FINANCIAL MINDSET FINANCIAL MINDSET OF AGRICULTURAL OF AGRICULTURAL

PRODUCERSPRODUCERS

AGRICULTUREAGRICULTUREdefined todaydefined today

Agriculture has been described as “asset rich and cash poor.” This is an extremely accurate definition. The land has probably been handed down for generations, the equipment costs in the hundreds of thousands of dollars, yet prices have remained relatively static.

COMPARISONSCOMPARISONS

PRICE OF COTTON

1950 - 40¢ per lb. 1990 - 67¢ per lb.

An increase of 68%.

COST OF EQUIPMENT(Tractor, planter, plow)

1950 – $18,000 1990 – $96,400

An increase of 436%.

AGRICULTUREAGRICULTUREfinancially definedfinancially defined

Irrational adj. 1.a Not endowed with reason. b. Affected by loss of usual or normal mental clarity. c. Contrary to reason; illogical.

Investor n. 1. A person that commits money or capital in order to gain profit or interest.

2001-2002 RMA2001-2002 RMACotton and Cash Grains ROECotton and Cash Grains ROE

Cotton Quartiles (SIC # 0131) 59.8 10.5 (11.1)

Cash Grain Quartiles (SIC # 0115) 14.8 3.8 (0.6)

2001-2002 RMA2001-2002 RMABeef Cattle and Hogs ROEBeef Cattle and Hogs ROE

Beef Cattle Quartiles (SIC # 0212) 16.2 5.3 (2.5)

Hog Quartiles (SIC # 0213) 66.4 27.6 14.2

COMMODITY PRICINGCOMMODITY PRICINGWhen preparing a FSA guaranteed loan, the Agency provides commodity pricing for calculating income. If current pricing is needed I use two sources:

1. ftp://ftp.fsa.usda.gov/public/ratespub/default.htm

2. http://www.ams.usda.gov/lsg/mncs/ls_amar.htm

BREAK FOR LUNCHBREAK FOR LUNCH

REMEMBER, IF YOU EAT, YOU ARE INVOLVED WITH

AGRICULTURE!

BENCHMARK RATIOS BENCHMARK RATIOS AND THEIR AND THEIR

CALCULATIONSCALCULATIONS

Farm Financial Farm Financial Standards Task ForceStandards Task Force

Identify certain ratios common to all areas of the country

Identify standard methods of calculating these ratios

Draw up standardized farm financial statement guidelines that may be used by all farm lenders

LIQUIDITY RATIOSLIQUIDITY RATIOS

MEASURES ABILITY TO TURN ASSETS INTO CASH:

Current RatioWorking Capital

CURRENT RATIOCURRENT RATIO

Current Assets

Current Liabilities

>150% is strong <100% is risky

WORKING CAPITALWORKING CAPITAL

Current Assets (–) Current Liabilities

Working capital is an absolute number and indicates how much flexibility the

producer has in managing the business.

LEVERAGE RATIOSLEVERAGE RATIOS

MEASURES THE AMOUNT OF OUTSTANDING DEBT:

Debt to Asset

Debt to Equity

DEBT TO ASSETDEBT TO ASSET

Total DebtTotal Assets

<30% is very strong >70% represents high risk

DEBT TO EQUITYDEBT TO EQUITY

Total Debt

Total Equity

<42% is strong financial position

>230% is high risk

PROFITABILITY PROFITABILITY RATIOSRATIOS

MEASURES EFFECTIVENESS IN TURNING SALES INTO PROFIT:

Operating Profit Margin

Return on Assets

Return on Equity

Net farm income from operations (+) interest expense (–) operator management

fee () gross farm revenue

>25% is profitable<10% is high risk

OPERATING PROFIT OPERATING PROFIT MARGINMARGIN

Net farm income from operations(+) interest expense(–) operator management fee() average total farm assets

>5% is profitable <1% is high risk

RETURN ON ASSETSRETURN ON ASSETS(mostly owned)(mostly owned)

RETURN ON ASSETSRETURN ON ASSETS(mostly leased)(mostly leased)

Net farm income from operations (+) interest expense (–) operator management fee () average total farm assets

>12% is profitable <3% is high risk

RETURN ON EQUITYRETURN ON EQUITY

Net farm income from operations

(–) operator management fee

() average total farm equity

ROE is a dangerous ratio: it can be artificially inflated by low equity!

EFFICIENCY RATIOSEFFICIENCY RATIOS

MEASURES PRODUCTIVITY OF YOUR BUSINESS ASSETS:

Operating Expense ratioInterest Expense ratioDepreciation Expense

OPERATING EXPENSE OPERATING EXPENSE RATIORATIO

(mostly owned)(mostly owned)

Total farm expense (+) interest expense (+) depreciation () gross farm revenues

<65% is very efficient >80% is high risk

OPERATING EXPENSE OPERATING EXPENSE RATIORATIO

(mostly leased) (mostly leased)

Total farm expense

(+) interest expense

(+) depreciation

() gross farm revenues

<75% is very efficient >85% is high risk

INTEREST EXPENSE INTEREST EXPENSE RATIORATIO

Interest expenseGross revenues

How important is borrowed capital?

<12% is a strong position >25% is very risky

DEPRECIATION DEPRECIATION EXPENSE RATIOEXPENSE RATIO

Depreciation expense

Gross revenues

If capital expense and term debt margin is greater than depreciation, then producer

can replace capital assets. If reversed, then could be living off of depreciation.

REPAYMENT REPAYMENT ANALYSISANALYSIS

MEASURES ABILITY TO MEET

REPAYMENT OBLIGATIONS

Term Debt & Lease Coverage Ratio

TERM DEBT & LEASE TERM DEBT & LEASE COVERAGE RATIOCOVERAGE RATIO

[ (Net farm income from operations

(+) gross non-farm revenue

(+) depreciation expense

(+) interest on term debt & capital leases)

(–) family living & income tax expense ]() scheduled principal & interest

and capital lease payments

COMMON FSA FORMSCOMMON FSA FORMS

CASE STUDIESCASE STUDIES

TREND & INDUSTRY TREND & INDUSTRY ANALYSISANALYSIS

display 3+ years financial history

compare to industry standards

use common-sized financial statements

perform ratio analysis against industry averages

IOU FARM & RANCHIOU FARM & RANCH

Robert E. Lee dba IOU Farm & Ranch is preparing for next year’s operating loan

FSA declared 1998 as a disaster year for the local area

Banker wants complete borrower plan for next year’s operation

PREPARING FOR THE PREPARING FOR THE BANKBANK

CHARACTERISTICS OF CHARACTERISTICS OF A AG LENDERA AG LENDER

1. Show understanding of agriculture as it exists today

2. Experience in ag credit and commitment to agriculture

3. Reputation for honesty and integrity

CHARACTERISTICS OF CHARACTERISTICS OF A AG LENDERA AG LENDER

4. Willing to discuss policies and terms and take prompt action to credit requests

5. Capacity to meet anticipated credit needs

CHARACTERISTICS OF CHARACTERISTICS OF A AG BORROWERA AG BORROWER

Arrange credit in advance

Allow lender to review plans and make suggestions

Inform the lender of problems and changes

Maintain a high level of integrity

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

Non-financial FactorsNon-financial FactorsConditions and Behaviors

– Poor production & marketing practice

– Investment purchases based on “paint fever”

– Family living costs exceeding 20% of gross farm revenue

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

Non-financial Factors Non-financial Factors (cont’d)(cont’d)

Conditions and Behaviors (cont’d)

– Increased health care costs

– Alcohol and/or drug abuse

– Marital problems and divorce

– Fraud and poor ethics

Stage 1:

85% doing

15% managing

Stage 2:

66% doing

34% managing

Stage 3:

34% doing

66 % managing

Stage 4:

15% doing

85% managing

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

Non-financial Factors Non-financial Factors (cont’d)(cont’d)

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

Non-financial Factors Non-financial Factors (cont’d)(cont’d)Problems created by the Lender.

– Debt Structure: Nontraditional lender offers low rates but short terms

– Financing assets beyond useful life

Problems created by the Lender (cont’d)

– Failure to judge repayment capacity (5-5-3)

– Misinterpreting financial information.

– Change in loan officers, shift in policies, buyouts/mergers

– Communications gap

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

Non-financial Factors Non-financial Factors (cont’d)(cont’d)

Outside Forces

– Weather

– Price change received for products

– Interest rate risk

– Decline in asset values

– Loss of assets due to natural disaster

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

Non-financial Factors Non-financial Factors (cont’d)(cont’d)

Downward trend in ROA or ROE

Living off of depreciation

A/P buildup, debt to family, credit cards

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

FFinancial Factorsinancial Factors

Failure to pay taxes

Cancellation of insurance

Operating expense ratio is >80% with Debt/Asset ratio over 50%

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

FFinancial Factors inancial Factors (cont’d)(cont’d)

Debt Coverage Ratio

declining or <1 for multiple

years

Financing operating loan as

long-term debt

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

FFinancial Factors inancial Factors (cont’d)(cont’d)

Interest expense more than

25% of revenues

Split LOC from many sources

(>5)

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

FFinancial Factors inancial Factors (cont’d)(cont’d)

Excessive family living

expense

Too much leverage:

D/A >70% D/E >230%

CAUSES OF PROBLEM CAUSES OF PROBLEM LOANSLOANS

FFinancial Factors inancial Factors (cont’d)(cont’d)

7 POSSIBLE OPTIONS OF A 7 POSSIBLE OPTIONS OF A WORKOUTWORKOUT

1. Examine ways to cut both fixed and variable costs: concentrate on 4 or 5 largest costs

2. Sale of capital assets: assets must have a market and are not critical to daily operations

3. Use outside incomes to improve the cash flow of the business (over expenses)

4. Reduce family living withdrawals (Yeah, right!)

5. Capital infusion from outside sources (usually not workable)

7 POSSIBLE OPTIONS OF A 7 POSSIBLE OPTIONS OF A WORKOUTWORKOUT

5. Lender options– Oral forbearance– Principal deferment– Principal and interest deferment– Complete re-amortization

7 POSSIBLE OPTIONS OF A 7 POSSIBLE OPTIONS OF A WORKOUTWORKOUT

6. Lender Options (cont’d)– Debt restructuring; requires high

equity (usually 70+%)– Voluntary liquidation– Voluntary conveyance– Foreclosure

7. Bankruptcy

7 POSSIBLE OPTIONS OF A 7 POSSIBLE OPTIONS OF A WORKOUTWORKOUT

AG FINANCIAL AG FINANCIAL STATEMENTSSTATEMENTS

Father to his adult offspring: “Someday I will let you see the books,” referring to the financial condition of the farm. The father is 71. The “child” is 42.

You wonder why some farms fail financially!