Dairy business expert Bob Matlick points out why banks' generic cash flow calculations can lead to poor lending decisions that may lull dairy producers into a false sense of security or insecurity.
By Bob Matlick, Frazer LLP
We all know about the volatility that has reared its ugly head in the production dairy markets. The volatility is on both sides of the equation – inputs and outputs, with the ultimate tsunami hitting in 2009. A majority of the large dairy lenders have reacted to this volatility by tightening their credit underwriting standards.
We have seen lenders drop the maximum Loan-to-Value (LTV) ratio from 75% to 65% (or lower), the reduction of collateral values of personal and real property, and the inclusion of payables into the LTV formula. We have also been introduced to "burn rate" calculations, additional security in the real estate holdings, and monthly or more frequent position reports. All of these actions point to securing a better position in the collateral base so the lender and producer can weather the increasing volatility. Bottom line, the lender may be looking at collateral liquidation as the main source of repayment as compared to ongoing cash flow.
What I have not seen is an increased focus on monthly and seasonal cash-flow projections by the lenders or increased visibility of risk management strategies. In a typical borrowing relationship, multi-page Excel cash-flow projections are prepared by bank personnel and then approved or amended by the producer. These are usually prepared in a monthly format for a 12-month period. These cash flows, along with the collateral base, become the underpinning of the credit approval process.
I have reviewed bank cash flows and, in many cases, found a very generic approach to the process by creditors. For example, monthly production per cow will be projected at a static level without any consideration for seasonality, and feed consumption (dry matter intake) will be projected on a fixed basis for each monthly period, ignoring seasonality and price fluctuations. Yet, seasonality in all the major income and expense categories plays a large role in monthly cash flow, especially through warm summer months when production per cow suffers and farming and harvesting expenses are at their highest levels. This issue is even more pronounced in large dairy herds.
I have also seen milking cow numbers projected at a static head count year round, and annual farming expenses will simply be divided by 12 and inserted as an unchanging monthly number. In my opinion, these types of projected cash flow generalizations can cause poor lending decisions on behalf of creditors and may lull dairy producers into a false sense of security or insecurity.
Many banks and creditors will then propose or enforce loan covenants based on these very generic cash flows. For example, "Milk income cannot vary by more than 10% of budget projections on a monthly basis," or "The monthly debt service must be equal to or greater than 1.25:1, budget to actual." While I understand the need by creditors to monitor cash flow (the main source of repayment for the loan(s) as opposed to collateral liquidation), I would encourage lenders and producers to understand and manage the monthly and seasonal variations that occur within a dairy operation.
This will take both effort and communication on both the producer and creditors behalf; however, it is crucial in developing a stable and functional credit arrangement with proper loan covenants. Without this full understanding of cash flow on both sides of the table, we will find creditors revert to collateral (Loan-to-Value) lenders with tighter and tighter restrictions to avoid the volatility.
Bob Matlick is a partner with the accounting firm of Frazer LLP. He has more than three decades of experience in the agriculture industry. Based in Visalia, Calif., Matlick is a management advisory specialist and provides business consulting services to the agriculture industry with an emphasis in the Western U.S. dairy industry. He has extensive experience in credit acquisition, buy/sell transactions, including tax-deferred exchanges, debt and management restructures of distressed agriculture financial situations, preparation of feasibility studies and facility relocation services. You can reach him at Bmatlick@frazerllp.com or at 559.732.4135 xxt. 107.