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Loan Covenant Clarity Is Key for Dairies

Jul 07, 2014

Questions you should ask about this increasingly important element in your annual line of credit.

Bob Matlick (resized) Blue

By Bob Matlick, partner, Frazer LLP

Most short-term (operating line) lenders now include financial loan covenants in the renewal documents of the annual lines of credit. If the covenant is broken, there is usually a period of time in which the customer can cure the default. If the default is not cured within the given period, the whole loan relationship can be terminated based on the default.

I find many of my clients do not understand the loan covenants nor do they understand the manner in which the particular bank wants them calculated. I must admit at times I am unsure of the calculation the lender is attempting to perform.

In general, prior to 2009, the only firm loan covenant monitored by the bank was the advance rate (or loan-to-value) on the collateral base (cows, feed, etc.). Since banks saw these loan-to-value ratios fail to monitor the overall financial health of a volatile industry, we are now seeing more specific covenants being included to assist in monitoring liquidity, overall equity and the ability of the operation to make the scheduled ongoing debt payments.

The first issue with loan covenants is to find them in the loan agreement. Ask your loan officer to point them out to you and explain them to you. Ask for an example of how the calculation is going to be made and what data is going to be utilized to make the measurement. The most important questions to ask are, "What is the purpose of the covenant?" and "What is the lender is attempting to measure?" Also, make certain you understand the consequences of defaulting on the specific covenant and the ‘cure’ period timeframe. The cure period is the window of time you have to bring the covenant into compliance.

While there continue to be the standard loan-to-value ratios in most dairy operation lending agreements, other common covenants are minimum liquidity requirements, debt coverage ratios, and minimum equity covenants. Make sure you understand how the loan-to-value percentage is calculated and what is considered eligible collateral (cows, feed and milk check receivable) and the corresponding offset (short-term debt, payables, etc.).

A liquidity ratio measures an operation’s ability to raise cash in a very short timeframe to cover monthly cash shortfalls. In the instance of dairies, the most liquid assets are cash and receivables. Remaining potential liquid assets are livestock and feed, which take time to sell, and may include steep discounts in a sale completed over a short timeframe. Sale of these types of assets will usually impact the ongoing operation in a negative manner. Most lenders are attempting to measure the dairy’s ability to withstand a period of negative margins (without utilizing trade vendors or borrowing) when this covenant is utilized.

A debt coverage ratio measures an operations ability to meet all debt payments over a given period of time. The lender wants to make certain that adequate cash flow is being generated from the operation to service all debt. This covenant needs to be fully understood by both the lender and the borrower as to how it is calculated as I have seen many different variations utilized within the dairy industry (cash vs. accrual, how is cattle depreciation utilized, etc.). Bottom line: Discuss and understand the calculation with your specific lender.

A minimum equity ratio is really a measurement of an entities net worth. Again, understand the calculation your lender is making. Is it on a Fair Market Value basis or cost less depreciation? If the calculation is based on cost, are certain assets revalued to fair market value (livestock)? Are deferred income and losses considered? Are taxable gains considered if liquidation were to take place?

In closing, most lenders are requiring an operation meet certain financial covenants. Make sure you understand what the purpose of the covenant is for your lender, if it is applicable to your operation, and how it is calculated.

Bob Matlick is a partner with the accounting firm of Frazer LLP. He has more than three decades of experience in the agriculture industry. 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

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