What your lender wants to know
Understanding your financial position means better communication.
Are you considering making plans for future expansion? Maybe you are working on establishing or re-establishing lines of credit. Obviously, lenders are going to want to review your financial records but what criteria do they base their decisions on?
According to Dr. David Kohl, an agricultural economist currently serving as a special advisor to RBC Royal Bank, lenders generally perform a three-to-five year analysis on five specific areas of financial performance:
- Your repayment ability
- Liquidity as the backup source of repayment
- Solvency – how much debt you carry
- Financial efficiency
Red light, green light
"By comparing your business to corresponding benchmarks from other producers, they will give you a risk rating. Their system is like a traffic light with green, yellow and red signals," says Kohl. "A green light implies low risk; a yellow light, moderate risk: and a red light warns of high risk."
However, Kohl points out, "Weaknesses in one measure may be offset by strengths in other areas. As well, variations may occur between industries."
A lender’s first step is to see if there is repayment capacity from earnings to meet the debt payment obligations. The most common measure is the term-debt and lease-coverage ratio.
"In my 25 years of teaching ag lenders, I have found the top operators generally have a coverage ratio approaching 200% with the bottom tier below 100% over a period of time. If a business is making a major expansion of adjustments, a minimum coverage ratio of 150% accounts for cost overruns or production and marketing problems," says Kohl.
If the ratio falls in the yellow or red light zone, Kohl says the lender might suggest risk-management strategies such as fixed interest rates, crop insurance, hedging, options or guaranteed contracts.
Next, liquidity as the backup source of repayment will be stressed by lenders. While lenders will measure liquidity using the current ratio, Kohl says there are several factors that can influence the interpretation of this ratio.
Dairy, contract hog and poultry producers as well as diversified operations often exhibit a lower ratio. However, these operations may still reflect favourably in the lenders’ eyes because of marketing contracts and frequent incomes.
Cash is king
"My experience finds top producers usually keep a 2:1 current ratio while marginal farms fall below 1:1. Liquidity will be king in the next five to seven years as we see greater volatility in costs and market prices and as some producers move toward value-added agriculture," Kohl warns.
When it comes to debt, a debt-to-asset ratio exceeding 50% will bring closer scrutiny by the lender. Feedlots, vegetable growers, horticulturists, dairy farms and leased operations carry higher levels of debt because of higher capital turnover.
A good plan, a little luck
For those over the 50% mark, Kohl advises the following action plan:
"First, be in the top 25% of production managers in your commodity holding costs under control. Second, be in the top 25% of marketing managers in your commodity and, third, be in the top third of cost-control managers. Keep living withdrawals at modest levels and hope for some good luck!"
Lenders measure financial efficiency by using the expense/revenue ratio as a key measure. Kohl says a green light benchmark is below 70%, "important if the debt-to-asset ratio exceeds 50%."
Kohl adds that "a higher ratio is acceptable if a large portion of the operation is rented or leased as lease payments are often substituted for principal or interest payments. Very large operations, nurseries or feedlots can also survive with higher ratios because they operate on larger revenue bases."