Editorial

Performance Based Borrowing

Good Financial Records Required

BY Robert Fears | | Comments (0)

Due to our federal government’s efforts to control inflation, money available for banks to loan, is limited. One of the results of this limitation is that you can no longer walk into a bank or loan office and borrow what you think you will need to run the ranch for a year with just a handshake. To obtain a loan, you have to present accurate, up-to-date financial records and show that your loan request is based on financial performance.

Danny Klinefelter, Extension Economist with Texas AgriLife Extension Service discussed performance based borrowing during the Next Generation Agricultural Conference in Bryan, Texas earlier this year. Klinefelter listed the following 12 questions, which need to be answered before applying for a loan:

How much money are you going to need?

You should be able to show the loan officer how much money you will need initially, as well as when the peak requirements occur during the loan period. Base your money needs on good expense estimates and plan for contingencies such as drought. Once you verify the amount of money you need to borrow, then estimate your repayment capacity including dates and amounts. The loan officer will want to know when he or she can expect to be repaid.

What is the money going to be used for?

Be specific when explaining how the money will be used. Support your needs with budgets and historical documentation. If the money is to be used for living expenses, refinancing, carryover debt or capital expenditures, say so before the loan is granted. Loan officers don’t like surprises and withholding information is not an honest way to do business.

How will the loan affect your financial position?

The common measures of financial position are net worth, financial structure, historical cash flows, profitability and risk exposure. Net worth is the difference between assets and liabilities and is expressed as the owner’s equity in the business. The specific mixture of equity and long–term debt in a ranching operation is financial structure. Historical cash flow records show cash receipts and expenditures during certain time periods as well as highlighting cash surpluses and deficits. Profitability is described by return on assets (ROA), return on equity (ROE), and operating margin (OM).  Risk exposure is measured by various financial ratios such as liquidity, equity to assets, debt to assets, and debt to equity. Provide documents that describe your financial position to the loan officer when you apply for the loan. These documents should describe your past financial position as well as a forecast of your position after the loan is received.

How will the loan be secured?

Collateral is adequate if, and only if, it will provide enough cash to pay the loan and its costs under the worst conditions. An important lending consideration on collateral is not what it is worth at the time of the loan request, but what its expected value is at the due date of the note or at the date of the next scheduled payment. More loans are now based on soft rather than hard assets. Examples of soft assets are leases and contracts and examples of hard assets are owned land and cattle. Regardless of whether soft or hard assets are used for collateral, the lender will determine its net realizable value before granting the loan. Net realizable value (NRV) is the estimated selling price in the ordinary course of business minus any cost to complete the sale of goods.

How will the loan be repaid?

Sources of the repayment may be operating profits, non-ranch income, sale of the asset being financed, refinancing, or liquidation of other assets. Be prepared to tell the loan officer which source you will use and be able to document its value.

When will the money be needed and when will it be repaid?

A cash flow budget is an excellent document for answering these questions. Cash deficits will be shown in the cash budget, which indicates when money will be needed from the loan officer. The cash flow budget will predict cash surpluses that can be used for loan payments. Use of cash flow budgets when talking with the loan officer will improve communication and understanding. Also, share a marketing plan with trigger points, which provide evidence that the plan is being followed. Contract terms and conditions and various pooling arrangements are often not adequately communicated or documented.

Are your projections reasonable and supported by documented historical information?

Too many producers still do not have production, marketing and financial records to demonstrate their track record and support their numbers. Complete and well- documented historical information is the key to getting a loan. Often loans are denied because the producer is unable to provide historical records or is unwilling to share them with the loan officer.

How will alternative possible outcomes affect your repayment?

Historical performance as well as current forecasts should be used to answer this question. Projections should address “what if” scenarios. Borrowers and lenders often evaluate the effects on loan repayment ability on a 10 or 25 percent decrease in revenues. For some ranches, this practice overstates the risk involved, while for others it may seriously understate potential risks. The considered alternative outcomes should reflect the ranch’s actual historical performance variability, as well as the range of current forecasts.

How will you repay the loan if the repayment plan fails?

Contingency planning is critical. Every plan should have a backup plan and every market entry strategy should have an exit strategy. This latter point is particularly true where niche markets are involved.

How much can you afford to lose and still maintain a viable operation?

Viable net worth is not just a positive figure. There is some level of net worth at which a lender refuses to continue financing the operation without an external guarantee or equity infusion. You need to know what this level is before the loan is written. Consider both possible operating losses and declines in asset values when determining how much you can afford to lose.

What risk management measures have been or are to be implemented?

Risk management measures can cover anything from formal management tools to stool or strategy, such as margin calls and pool advances.

What have been the trends in the ranch’s key financial position?

Klinefelter asks, “Do you know? If the trends are adverse, what are your specific short- and long-term plans for turning things around? The ability to take timely actions and manage problems is hard to measure, but as risk increases, it becomes critical in the credit decision process.”

Current high costs of operational inputs and capital purchases require most ranchers to depend on borrowed money to keep the ranch in business. Taking a complete and accurate set of financial records to the loan office is necessary for continued credit.

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