Running a farm not only takes an ability to determine market prices for product sales (revenue) and the estimations of operational costs (expenses), but also the capital expenses necessary to keep the farm running or, in some cases, to expand operations. In this lesson, we will look at different ways that a small farm can fund capital expenses – those farm costs and investments that are expected to last longer than a year.

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As we have seen in the first four lessons, there are many different types of costs associated with running a business. In general, a farmer will need to determine the amount of revenue needed to cover her monthly (or daily) fixed and variable costs and price her products accordingly. These are considered reoccurring expenses and are the costs of doing business. However, sometimes a farmer will need to make a larger investment into the farm – for a piece of equipment or the purchase of additional land or the purchase of additional livestock. The farmer may even be considering expanding into a new line or business. These expenses are called capital expenditures and are made for equipment or assets that will be used for more than a year to run or expand the business. Because their life is longer than a year, they are not paid for out of the revenue received from product sales. They are either paid for out of cash on hand (the farmer’s savings) or, more typically, they are purchased using financing from a bank or other lending institution.

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This slide shows a list of different types of capital costs that a farmer might encounter. It can include the purchase of an asset that has a life longer than a year as well as the purchase of the assets of an existing business (say, if a grass-fed beef farmer were to acquire an organic strawberry farm). Capital costs DO include the labor and additional expenses needed to get the asset up and running (for example the labor to renovate an existing farm building), but DO NOT include the additional operating costs (for example the feed needed for 10 additional cattle).

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There are a variety of ways to pay for a capital expense. One of the easiest is to use cash from an existing checking, savings or investment account. However, in general young and beginning farmers might not have cash available. Using a grant or incentive (as described in the last lesson) is a good way to reduce the overall cost of the purchase. Many grants do not cover the full purchase price, but can be used to reduce the overall cost. Credit cards can be used to finance small purchases, but generally carry high interest rates. Interest is the amount paid to the bank or financial institution offering the financing (a payment in return for lending out the money). Credit card interest rates can vary from 9% to up to 25% of the actual loan amount (vs. traditional loans which are generally under 10%). Because of the high interest rates charged, credit cards are generally NOT a good way to finance a capital purchase. A mortgage is a loan for a piece of property (land or building). Over a period of many years, the borrower repays the loan, plus interest, until he/she eventually owns the property free and clear.

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A lease is a contract renting equipment, land or buildings. A lease does not end up in ownership of the asset, but it does give a farmer the opportunity to use the asset to grow or expand the farming operation. A loan is money given out temporarily to fund the purchase of an asset. The money is expected to be paid back over time, usually for a specified amount of interest. Once a loan is repaid, the farmer owns the asset. There are other (more complicated) types of financing options, but these cover the primary ways that a farm finances its capital expenditures.

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Besides financing a capital expenditure with cash on hand, loans (or debt-financing) are the most common way for a farmer to make a large purchase. There are a number of different types of loans that a farmer might use: Friends and relatives might be willing to lend out money at lower (or zero) interest rates for smaller capital expenditures. This method of financing a purchase should be used with caution, however, and a repayment schedule should be worked out to ensure that the friend/relative gets repaid in a timely manner. Traditional Lending Institutions, like banks and credit unions, are the primary source of financing for many businesses. These lending institutions will generally have strict credit score requirements for the borrower and require some sort of collateral for a loan (usually an asset that is pledged to secure a loan). However, the interest rates and repayment terms for bank and credit union loans are generally very attractive for farmers that qualify. Community Development Financial Institutions are mission-driven non-profit organizations that serves a specific target market in a community. Many CDFIs are based in rural communities and support economic development activities (including

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farming). Nationwide, over 1000 CDFIs serve economically distressed communities by providing financial services that are often unavailable from traditional financial institutions. The federal government offers many loan and loan guarantee programs to help businesses (especially start up business) acquire financing. The Small Business Administration offers a variety of loan programs to eligible small businesses that cannot borrow at reasonable terms from traditional lenders. The USDA Farm Service Agency has a similar program specifically for a farmer or rancher who is unable to obtain credit elsewhere. Unlike loans from a commercial lender, SBA and FSA loans are temporary in nature with a goal to help the farmer “graduate” to commercial credit. Note: If you have time, the FSA’s guide for Farm Loan Programs is an excellent reference for the types of loan programs available: http://www.fsa.usda.gov/Internet/FSA_File/fsa_br_01_web_booklet.pdf

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The American Bankers Association offers the following tips for young and beginning farmers who are looking to get financed by a bank. Using the teacher handout as your guide, walk the students through some of the provided tips (refer to “ABA Tips for Young Farmers.” You can choose to discuss some or all of the tips provided on the sheet. This slide outlines a few of the most important. Note that in the next week, this unit will discuss how to evaluate the cost/benefit of a project as well as how to develop a business plan.

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A basic loan application will ask for information about you, about your farm and about the project you are hoping to finance. It is important to accurately estimate the amount of money that you are looking to borrow. The loan decision will be made based on your personal credit score as well as your ability to repay the loan. Your credit score is based on your payment history for other types of loans (credit cards, auto loans, other). As a young farmer, you may not have established a credit history and may need a parent or sponsor to be a co-borrower or guarantee the loan. For larger loan requests, it is a good idea to prepare a business plan that provides a road map for how you will move from where you are now to where you want your operation to be in the future. Your business plan is very important to a lender. It shows that you have seriously thought about your goals and plans for the future and that you understand all parts of your operation. How to develop a successful business plan will be discussed next week.

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Split the students into two groups. One half will be a lender. The other half will be a farmer applying for a loan. Give the “lender” group a copy of the USDA Youth Loan Application (this is an actual application used by the USDA). Ask each “farmer” to find a lender and sit across from each other. Have the lenders conduct a financial “interview” and ask the questions on the application. The “farmers” can either answer the questions from their own experience or use the Piedmont Farm case study as an example. The purpose and amount of the loan can be entirely up to the student. Give the students 30 minutes to complete the application. When they have completed the application, bring them back together to discuss their thoughts on the application. Were the questions hard to answer? Were there pieces of information that they didn’t know the answers to? Was the process complicated? For the lenders, were there other pieces of information they would have liked to have known about the farmer? More and more frequently, loan applications for all types of loans are available online, but many lenders do want to meet with borrowers in persons to discuss a

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loan application – especially for first time borrowers. It is important for the borrowers to be prepared to answer these types of questions in order to receive loan approval from the lender.

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In the next class, we will start discussing Piedmont Farm’s proposed innovation – a solar panel installation – and begin to look at how to prepare a cost/benefit analysis to determine if the farm should move forward with the investment.

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