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FOR
YOUR FARM BUSINESS Cooperative
Extension Service Department
of Agricultural and Applied Economics June
2002 Prepared
by Cesar L. Escalante, Assistant Professor
At times, however, the borrower's
failure to fully repay his/her loan is a consequence of faulty packaging
of loan terms and conditions. Under these situations, the borrower’s repayment capabilities given
expected cash flow and liquidity conditions either have not been realistically
assessed or do not match with the repayment provisions stipulated
in the loan covenant. The choice of specific loan terms
and conditions must not only conform to lenders’ expectations of their
profit and liquidity conditions. More
importantly, the lender should carefully adapt certain terms and conditions
to a realistic projection of the borrower’s financial condition, liquidity
structure and repayment capacity.
The following sections will discuss several attributes of the
loan package that need to be carefully matched with specific borrower
types. A. Loan Maturities
and Purpose
Definitions In
terms of maturities, the USDA reports categorize farm credits into
farm real estate and agricultural production loans.
Farm real estate loans may be either intermediate
term or long-term in nature. Farm
real estate properties and other farm assets are the preferred security
for this type of loans that are used for the acquisition of farm assets. Intermediate-term loans, with terms ranging from 18 months to 10
years, are used to finance the acquisition of such depreciable assets
as farm machinery and equipment, breeding livestock and improvements. At times, these loans may also be used to finance
additional working capital requirements of the farm business in order
to restructure the borrower’s balance sheet (Ellinger
and Barry). Long-term loans
carry a term of more than 10 years and are used to finance the acquisition,
construction and development of land and buildings. Agricultural production loans are used to cover the farm’s short-term
liquidity needs and are used to finance operating expenses. This credit facility has short-term maturity,
ranging from A
line-of credit facility could either be revolving or non-revolving. Under a revolving line-of-credit,
the borrower may draw on the line more than once as needed subject
to a cap on the cumulative amount of the drawings and a specified
time period. A non-revolving line-of-credit
entitles the borrower to a specified amount of funds and does not
allow successive drawings on the line even after repayment of the
drawn funds. Discussion: Common Pitfalls Borrowers
should always understand that lenders would never make loan decisions
that they perceive to be detrimental to their institution's overall
financial health. In this regard,
the lender only decides to grant a loan under terms and conditions,
including the amount and maturity of the loan, that are favorable
from the lending institution's perspective.
In
times of high income and credit risk in the agricultural sector, the
farm lenders normally implement risk management strategies reflected
in the nature of credit decisions they make.
The following are a couple of possible strategies lenders might
implement to protect their interests in a credit transaction. a. Lending Less Than Requested A
lender may opt to reduce risk exposure to the farm sector by lending
less than the amount they usually lend to farm borrowers.
Thus, farmers have to make do with borrowed funds less than
the amount their businesses actually require. If the farmer is unable
to seek elsewhere the remaining amount of funding required by his/her
farm, the farmer may not be able to realize the full potential of
his/her farm business. There is considerable risk and danger in pursuing
a business project even if the amount available to finance the project
is less than what is actually required. The borrower stands to lose more by pursuing
project plans with deficient funding endowments. b. Shorter Maturities A
lender may also opt to continue granting exactly the amount of loans
requested by farm borrowers but limits the term of the loan. Shortening the term of the loan by even a few
years may have detrimental effects on the viability of the farm business. Shorter loan terms result in larger periodic
payments for the borrowers, which, in turn, could create cash flow
or liquidity problems for the farm.
An extreme example is a farmer who acquires new machinery and
equipment using the proceeds of a one-year credit line.
Machinery investments are usually larger than ordinary operating
expenses so that ideally machinery and equipment loans should be financed
by intermediate term loans with average maturities of 5 to 7 years.
A mismatching of the purpose and term of the loan can create
severe liquidity and viability problems for the farm business. The
following example illustrates how (equal) quarterly loan amortization
payments for a $500,000 machinery loan change as the term of the loan
is reduced at different interest rate levels:
The
above summary indicates that the quarterly loan amortization increases
from a range of about 12% to 94% with every one-year reduction in
the term of the loan. The incremental
amortization payment becomes increasingly larger as the term of the
loan approaches one year. Moreover,
increases in interest rates translate to larger absolute increases
in loan amortization payments for every one-year term reduction. It
is therefore important for the borrower and the lender to ascertain
whether or not the liquidity structure of the farm business will be
able to afford increased loan amortizations arising from a reduction
in the term of the loan. B. Payment ArrangementsFarm
borrowers should be cognizant of demand clauses in the
loan agreement. These provisions
allow the lender to demand payment from the borrower at any time during
the life of the loan. In the absence of these provisions, loans availed of under a line-of-credit financing arrangement are usually repaid when the borrower has surplus funds during the stipulated length of the credit line. Repayment of intermediate- and long-term loans, on the other hand, follow a payment (or amortization) schedule prepared by the lender that specifies principal and interest payments (amortizations) to be paid at certain maturity dates over the life of the loan. There are at least three payments options to consider for the repayment of intermediate- and long-term loans: 1) Fixed, Equal Payments: A fixed amount covering principal and interest charges is paid at stipulated amortization dates. This fixed amount is calculated based on specified interest rate and maturity (term) of the loan. Thus, loan amortizations are fixed and equal over the specified term of the loan. Each loan payment is allocated between principal and interest, with principal payments accounting for larger portions of the equal installment amount as the loan approaches maturity. 2) Fixed Principal Payments: Under this scheme, the original loan amount is repaid in equal principal installment payments over the life of the loan. Interest charges are then calculated based on declining principal balances. Farm borrowers must evaluate their liquidity and cash flow conditions in considering this payment option. The farm’s ability to adequately cash flow should coincide with the larger initial payments of principal and interest that are typically required under this arrangement. In general, this payment method results in less total interest charges over the life of the loan since a relatively larger portion of the loan amount is retired earlier compared to the fixed, equal payment scheme. The following table provides a comparison of the loan amortization schedules under the fixed equal and fixed principal payment schemes:
Another version of this comparison that calculates amortization payments on a quarterly, instead of annual, basis is presented in Appendix 1 for further reference. 3) Balloon Payment: These are relatively shorter-term loans. Under this arrangement, initial payments are usually based on a longer amortization period (such as 20 years) under the assumption that at the end of a certain shorter period (for example, after the first five years of the term) the loan with either be paid off, renewed or re-financed. In other words, at the end of the shorter period agreed upon, the entire unpaid balance of the loan becomes due so the borrower has the option to pay the amount in full or negotiate for new loan terms. Table 3 presents an example of a balloon payment type of arrangement:
Based on the above example, the borrower either pays the entire outstanding balance of $390,120 at the end of the fifth year or negotiates for a new set of loan terms. The borrower’s decision to negotiate further may depend on interest rate conditions. If at the time of negotiation, interest rates are falling and credit conditions are improving, the borrower may decide to negotiate for more favorable loan terms. However, if interest rates are rising and the credit situation becomes tight, either the newly negotiated loan terms may be unfavorable or the lender may decide not to renew the loan if the borrower’s risk rating becomes unfavorable. Again, this scheme needs to be evaluated according to the farm’s ability to generate cash flows that will adequately cover loan amortization payments, especially the bulk payment amount required at the end of the term of the loan. Discussion: Expected Profitability ą Liquidity Again, the borrower and the lender must consider the farm business' cash flow and liquidity structures in choosing the most appropriate amortization plan for the farmer's term loan. A glaring oversight that some people make is to consider only expectations surrounding the profit-generating capacity of a certain business project and ignore the resulting cash flow structure. Expected profitability is not usually translated to favorable liquidity conditions each month or period in the life of a business. Farming provides a perfect example of a business with some cash flow gaps resulting from the gestation of farm production, or that period ranging from the planting of crops till the time they are harvested, marketed and converted into cash that flows into the farm business. Some farming enterprises have longer gestation periods than others. However, a diversified farm business enjoys the advantage of being able to minimize cash flow gaps during the production year by planning and coordinating properly the end of the production cycles (marking the period for harvesting and marketing) of the enterprises whereby a certain enterprise is able to generate cash inflows that subsidize the cash outflows of the other enterprises that are either just in the early, middle or later stages of the production process. A more stable cash flow structure for this type of business could well afford either the fixed equal or fixed principal amortization plans. Highly specialized farm businesses, on the other hand, may have more limited capabilities is spreading out the timing of cash inflows to minimize cash flow gaps. Liquidity management for existing specialized businesses entail building up adequate cash and/or credit reserves to draw upon while waiting to realize revenues from the business. These farms should carefully choose the payment plan most appropriate to their cash flow structure. C.
Interest Rates and Other Loan Pricing Issues A loan may carry either a fixed or variable (or adjustable) interest rate. A loan may carry a fixed interest rate until the loan is paid off. Other lenders may offer a fixed rate only for a specified period of time, then the borrower and lender negotiate for either a new fixed rate or a shift to variable pricing thereafter. A variable or adjustable rate loan involves provisions to change the interest rate based on changes in market conditions, a specified index or other factors determined by the lender. The intervals in which interest rates change may also be designated, although in some cases decisions to change the interest rate are at the lender’s discretion. In any case, the borrower should always be aware of the frequency and magnitude of probable changes in the interest rates applied to his/her loan. Moreover, he/she should be able to calculate the effects of such changes on loan payments. The following concepts are important in the understanding of the pricing of a particular loan. These are features of the loan transaction that farm borrowers may negotiate with their lenders. § Rate buy-down: A reduction in interest rate can sometimes be negotiated with the lender in exchange for a one-time fee paid at the time of the origination of the loan. This arrangement is known as a rate buy-down. The potential benefits of this strategy to the farmer could be evaluated by comparing the present values of payments with and without the rate-buy down scheme. § Interest rate index: This index is used to determine the level of a variable or adjustable rate. Examples of indexes used by lenders include their own average cost of funds, the company’s internal rate, one-year Treasury securities rates, 90-day Treasury bills, federal funds rate and the London Interbank Offer Rate (LIBOR). The frequency of change in these indexes varies so the borrower is advised to obtain as much information from the lender about this issue. § Margin: This refers to the percentage points that the lender adds to the interest rate index to determine the price of the loan. Margins are designed to cover the lenders’ loan administration costs, the risk premium associated with the borrower’s credit risks and the lender’s expected profit margin. § Caps: These establish limits on the change in the level of variable or adjustable interest rates. § Prepayment Penalty: This is a fee charged by the lender when the loan is paid before maturity. Some lenders impose this penalty in order to realize the interest income they expect to generate over the life of the loan. This expected income is minimized by unexpected prepayment of the loan, thus the need for such income re-capture mechanism. § Late Payment Penalties and Foreclosure Provisions: A borrower should be aware of penalties associated with late amortization payments as well as grace periods defined in the loan agreements. Also, the borrower should be cognizant of specific conditions of default, such as the extent of delay in payments and non-payment of amortizations. Reference Ellinger, P. N. and P. J. Barry “A
Farmer’s Guide to Agricultural Credit.” Center
for Farm and Rural Business Finance,
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