Farm Debt Levels in Financial Statements
By John Hunt, Partner
BDO Dunwoody
What Does the Banker See?
You’re putting together a plan to talk to your banker about a loan for an expansion proposal, or a significant new piece of equipment. What is the banker going to look at in assessing your proposal? There are a number of factors the bank will consider before approving your loan; they include:
- Financial Statements and Ratio Analysis
a. Cash-flow
b. Debt servicing capacity
c. Debt to Equity and Equity to Assets ratios
d. Expense management
e. Forecasts
f. Track record of meeting budget/plans
- Collateral
- Integrity/character
- Management ability
Financial Statements and Ratio Analysis
In assessing your loan application, your banker will review your annual financial statements for most likely the past three years as well as review your business plan for the next two years.
Listed below are some of the key pieces of information the bank hopes to glean from these statements.
Cash-flow management - Do operations generate enough cash-flow to finance normal equipment replacements or breeding herd replacements, or does the operation seem to need to finance these normal replacements all the time? Are family draws controlled or is the family spending beyond its means? Is there off-farm income not included in the financial statements?
Debt-servicing – Does the operation generate a comfortable amount of cash income in excess of the annual principal and interest commitments it has to its lenders? Or is cash-flow already tight so that there is barely enough cash generated to meet present commitments? Will the expansion plan generate enough additional net cash-flow so that the operation will still be able to meet its debt servicing requirements?
Debt management – What is the current level of equity in the business? To what degree is equity leveraged with debt? One simple ratio to measure this would be to divide Equity by Total Assets and the result is your percentage ownership of your operation. Another useful ratio would be to compare Total Liabilities to Equity to determine your debt to equity ratio. Make sure to review the trends of these ratios over the past few years – are they improving or sliding? What affect does your expansion plan have on these ratios?
Expense Management – Are operating costs well-controlled or are you a high-cost producer? Do you know what your per acre or per head costs of production are, and are you conversant in what they should be? Talk to your lender, talk to your accountant, consult your feed or crops advisors; they can help you benchmark figures.
Forecasts – Have you prepared forecasts to illustrate the impact on your operation of the expansion over the next couple years? Is the forecast reasonable and have you considered all related expenses? Bankers see many proposals and will very quickly point out holes in forecasts that have not been thought through fully.
Past track record – Have you prepared forecasts and business plans in the past and did you meet them? It’s one thing to forecast something, it’s another to meet it. A track record of generally meeting forecasts helps to add credibility to the current plan. A history of missing deadlines and important plan details does not bode well for the current financing request.
Collateral
The days of lending on collateral and little else are long gone, and rightly so. That being said, banks still require a fall-back position. Banks never go into a relationship with a client with the expectation of needing to realize on security. But what happens if the plan doesn’t work? The bank needs to protect capital, and will of course secure the loan to have good coverage in the event that things go badly.
Typically, if the operation is an older established one with lots of equity, perhaps a new mortgage on a farm or two will satisfy the extra security requirements for the expansion. However, in a newer operation, additional security beyond mortgages are often the norm, including the requirement for loan guarantees, life insurance on the owners, general security agreements covering all assets of the business, limitations on future owner draws and future capital expenditures, maintaining pre-determined debt-servicing ratio levels, etc.
Integrity and Management Ability
An individual must also have a reputation of dealing honourably in its business dealings with suppliers, other farmers and lenders. Intangible leadership qualities coupled with a solid reputation could make all the difference in securing your loan.
Another few things to consider are, whether the producer has demonstrated management ability in terms of good production as well as low-cost production. Does the producer manage risk with good marketing practices, or is the producer a price-taker? Are other risks mitigated through the use of crop insurances, participation in farm-support programs, proper employee training practices as required under the Occupational Health & Safety Act, etc.? Does the farmer operate a “clean” operation with attention to detail and with proper environmental standards? Does the producer look to incorporate value-added opportunities into his or her operations, such as the capability to produce timely internal financial statements and whether a computer program is currently being used to generate them?
The integrity and management ability of the borrower can have a significant weighting in the overall decision of the lender as to whether or not to support an expansion plan. Many of the above factors are interrelated, and good cost control, as noted under the financial ratios area, is an indicator of good management ability. The same can be said for a track record of meeting budgets.
The next time you plan to talk to your banker about a significant new loan, have a look at these factors and see how you stack up. Bankers will be looking at them and more in their assessment of your proposal.
For more information, call your local BDO office or contact our National office at:
Telephone: 1-800-805-9544 Fax: (416) 367-3912 e-mail: info@bdo.ca
This bulletin is a publication of BDO Dunwoody LLP on developments in the area of taxation. This material is general in nature and should not be relied upon to replace the requirement for specific professional advice. The information in this bulletin is current as of December 31, 2005.
© 2005 BDO Dunwoody LLP
