It's Not About Your Equity

January 2, 2016 01:48 AM
It's Not About Your Equity

By Peter Martin

Like most farmers, the bulk of your net worth is likely in the equity of your ground. But you might have discovered a “land rich” net worth, even a sizeable one, doesn’t assure banks will approve a loan renewal.  

Generally speaking, ag lenders are cash-flow lenders. Like you, they don’t like low commodity prices. While your net worth is important to them, they’re far more interested in a positive cash flow that allows loan payments to be made as agreed. That’s not easy today. Many of you are struggling to pencil out a breakeven, let alone a profit. And then there are loan payments. As a result, many farmers face troubled loan renewals. Don’t fall for the flawed argument that equity alone will get you through your renewal, but do tout your equity as additional support for your request.

To understand how lenders approach renewals, keep in mind they conduct a careful repayment analysis of each borrower. If you have multiple entities, this should be done on a “global” basis. Built into this analysis is an industry threshold of at least $1.15 in cash available to service debt (cash flow to make payments) for every $1 in debt service (loan payments). Put another way, if you have annual debt service of $100,000, you’ll need to be able to show $115,000 in cash available to service that debt. For some lenders, especially on new requests, the threshold is $1.25.

To gauge whether you have the required capacity, lenders look at your available repayment sources. It’s key to understand your farm’s profits—not your equity—represent the primary source of repayment for term loans. If profits are insufficient to adequately service debt at the $1.15 level or higher, your lender will look to secondary sources of repayment. Common secondary sources of repayment might include off-farm income, ancillary business income and investment income.

If these two sources fail to provide adequate means to service debt, the loan has become distressed, and lenders will look toward tertiary sources for repayment. This typically involves liquidating assets, which is where your net worth comes into play. There it is: Your net worth is neither the primary nor secondary source of repayment.

Your net worth is important because it provides options. It provides an outlet for addressing stagnant operating debt—the “stuff” that somehow ends up on every farmer’s operating line but has nothing to do with getting your crop in or out of the ground. Stagnant debt should be “termed out,” and you’ll need your net worth to collateralize this.  

But perhaps the most important benefit of your net worth is its ability to generate cash. Every farm ought to be scouring its operation for unused or under-used assets. I’ve yet to come across a farm without an extra pickup or some other asset not being used efficiently. Get rid of this stuff now. The cash it generates is way more valuable. If things get really ugly, you can liquidate assets to protect the rest. While an unpleasant thought, it’s far better than the fate of those without a net worth.  

Equity is important, but it’s not the driving force behind renewals. Be prepared to show your lender what your primary and secondary repayment sources look like. Quantify how much cash you could generate by liquidating excess assets if repayment became strained. Finally, have a game plan if all hell breaks loose and converting a portion of your net worth to cash becomes necessary.  

This column is not a substitute for financial advice. 

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Spell Check

storm lake , IA
1/14/2016 08:04 AM

  cashflow is important, but this article is quite a ways off base. for example, a farmer with a 10 million dollar net worth whose cashflow does not show 115% debt service this year will not hear his banker say 'distressed'. if he hung around he would hear his banker say he/she wishes they had 100 more just like them. equity is extremely important when commodity prices are low. cashflow is not even one of the metrics we use to risk rate our ag customers. current ratio(liquidity), debt:equity, net worth trend, and working margin(a ratio of working assets less debt against those assets divided by that same debt number. we monitor and discuss likely cashflow, but it is not a reality only a projection, and we treat it as such. when times are tough farmers are rewarded for their past performance, not the unknown year ahead. sincerely, an ag lender in small town iowal

three 40s
cokato, MN
1/14/2016 08:24 AM

  Thank you mike from storm lake, i have always said keep your debt load in line and pay off loans early, that show good performance and i asked my lender if my efforts in the good times was the right thing to do and they look at that very much and in these times it has a great bearing on things. along with a great communication channel with lenders at any given time in life. Thanks mike

Western, NE
1/14/2016 10:44 AM

  I got a chuckle out of Mike from Iowa's response. Having been a lender through the 80's, the majority of the farmers that made it were the ones with the positive cash flow. Each year the farmers that utilized Mike's formula below saw their net worth evaporate to the point of no additional operating loans and partial to complete liquidations. Those banks that were solely net worth lenders collapsed. The successful farmer is one that plans and works his plan. Doesn't just put together a cash flow for his lender to get through the year. This year is a tipping point. I would look at the farmer's past performance, communication, 2016's net worth erosion (based upon that wonderful cash flow) and how realistic is the projected cash flow. Finally, I'd look at his market based financial statement compared to his GAAP financial statement to see the difference in net worth. If you're looking at making your lending decisions solely on a market based financial statement, you're setting yourself up to liquidate your customer! All the ratios Mike has written below mean absolutely dick if you have no plan to meet your 2017 obligations as the result of a poor 2016. In other words, it may also prove helpful to look at 2017 along with 2016.


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