In recent articles, I suggested to readers that credit in agriculture is tightening. This is a result of stressed economic conditions, particularly in the grain industry, more scrutinizing by federal and state regulators and increased oversight. In the regulators defense, avoiding another financial crisis, similar to the 2008 to 2009 period is their top priority. These individuals are tasked with oversight to ensure the lending industry stays on track; particularly, in agriculture.
On a recent webcast, a lender asked for my observations on the following scenario. Some of his producer clients had cash flow shortfalls for 2014 as well as in their projections for 2015. Many of these producers have an excess of 70% equity. Yet, their credit status was downgraded due to the cash flow shortfalls. He asked if I am observing this as a trend nationally.
My answer is yes. However, it is more common in some of the areas of the country than others depending on the commodity mix. For example, specialized grain areas are experiencing more negative cash flow versus a livestock or combination operation where losses can be better absorbed or offset. Regardless of equity, this type of scenario may continue and intensify into 2016. Producers need to be aware of this issue as well as the fact that securing operating monies may be more difficult. Lenders face a serious dilemma and producers must help themselves and their lender by presenting a defensible case for the regulator scrutinizing the account. My message to the regulator is as the old cliché puts it, “don’t throw the baby out with the bath water.” Each case must be examined on its own merits. However, you are not helpless in this situation and can take measures to strengthen your case both for the lender and the regulator.
Yes, 70% equity is very good as usually any number above 50% equity is considered sustainable debt. The producer needs to work side-by-side with the lender to historically ascertain whether the business is profitable. However, please take note that true profitability cannot be determined by a Schedule F tax record; but rather, by accrual adjusted income statements. This will show adjustments made for inventory, payables, prepaids, receivables, etc. A Schedule F tax record gives a false sense of profit and loss. Studies from Purdue University and University of Illinois indicate up to a 60 percent difference between tax records and accruals. It is the producer’s responsibility to do the adjustments to determine true profit. Otherwise, without this work you may also find yourself in line for possible credit status downgrade.
Next, you must have working capital. It is important to know how much of your working capital is price protected by a marketing plan, contract, crop insurance or combination of all three. Working capital amounts above 30 percent of revenue indicate to the regulator the strength of your credit and should provide at least some protection to your credit status.
In this situation, the best advice I can give to the producer is to build a case based upon a trend, not one or two years. Have you made profits in the past, built up a supply of working capital, increased your balance sheet through retained earnings versus asset appreciation or paper wealth? These will be important aspects of your case not only for the lender but also for the regulator in charge of oversight. A good, solid case requires accurate, up-to-date financial statements including projected cash flow within different financial scenarios. This type of work serves as an advocate for you and your business. Additionally, it can also illustrate needed improvements you can make to strengthen the business further.
This type of scenario truly is a lender’s dilemma. Increased oversight and regulation limit your lender’s flexibility. Be aware of this situation and be prepared! Make sure your financial records are up to date and accurate. Maintain adequate working capital. Determine true profit and highlight the trends over time in your business. Financially speaking, build a case for your lender who in turn can build a case for you with the regulator. A little extra work may make a big difference!