Speak the Language of Your LenderPosted in: Business By Bill Strautman June 1 2009
Most farmers prefer the tractor seat to the office chair, especially when it’s tax time. But a few well-spenthours with your financial statements can make a big difference when you visit your banker for financing.
“I was at an agronomy conference this winter and realized how much progress we’ve made with production. You think about the advances we’ve made in agronomy - seeding systems, chemical control of pests, nutrient management, variable rate seeding, GPS and autosteer – there’s been so many,” says Earl Smith, a farm management consultant with Wheatstone Consulting Inc., based in Olds, Alberta.
“Then you look at the farm business management side and I think it’s fallen behind. If we’re going to move the industry ahead, we need to ratchet up that side of it.”
Be the best at knowing your numbers, and your banker may just beat a path to your door
Part of it is that farmers like the production side more than they like the numbers and business management side, says Smith, former prairie manager of agriculture and agribusiness with the Royal Bank. “Farmers are always forward thinking – always looking forward to next year. You get your financial statements four months after the year ends, you’re already into planning the next year and I think farmers don’t spend enough time looking at those statements. Tracking the trends so you understand what’s happening over a number of years, to see the direction their business is going.”
“It’s a matter of being on top of those numbers, not just getting the statements from the accountant, filing them away and pulling them out to give a copy to the banker when he asks for them. It’s actually spending some time on them yourself, as a business manager. If we spent as much time scouting our numbers as we do our crops, we’d be in good shape.”
Smith says doing ratio analysis and a cash flow projection can put you in the driver’s seat with your lender. Three simple financial ratios calculated off the income statement and balance sheet can provide a lot of clarity in terms of how you’re doing year over year.
“The first one is current ratio, which is the relationship of current assets to current liabilities. If you divide those two, you get current ratio and if you subtract them, you get working capital. It’s simple to do, it takes you two minutes,” he says.
The key with all these ratios is to understand what your number is, then what your financial institute is looking for. You find that out by asking your lender what he’s looking for in terms of a current ratio.
“Say your bank wants a current ratio of 1.25 and you’re at 1.6 – you’re doing okay. Or you’re at 1.1, then you might want to look at increasing your operating loan. Once you get your financial statements, you go in saying ‘My current ratio has gone down, here are the reasons why, I think I need to bump my operating loan up’,” says Smith.
“That’s way better than coming in on July 15 saying ‘I’m out of money and I need an increase in my operating loan to get through the rest of the year’. It’s exhibiting professionalism and a business approach.”
The second ratio is a leverage ratio and the one Smith likes to use is debt to equity – total liabilities versus owner’s equity, right off the balance sheet.
He says every financial institution will have a different guideline for what they’re looking for. Different types of operations require different debt to equity ratios.
“If you’re in a manufacturing business you can be way more leveraged than if you’re grain farming, because of the nature of the business and the amount of cash you turn,” he says.
“A grain farm has one production cycle per year so it can’t be too highly leveraged because if it has a bad year, it has a huge impact. A dairy farm has daily production, so it’s in a lot different situation.”
Debt service coverage
Smith says the third one is a little more complicated but you need to understand it. It’s debt service coverage. That’s looking at what kind of cushion you’ve got, with money available to service the debt payments you need to make in a year.
“The concept becoming common in the business world, that we need to get farmers thinking about, is EBITDA. That stands for earnings before interest, taxes, depreciation and amortization. It really is the cash available to service debt,” says Smith.
“You compare that to how much your interest and principle payment are in a year, to see what your cushion is. If you’ve got $200,000 of payments to make and cash available of $220,000, that’s pretty tight and if you have a hiccup, you might have trouble making it. If you have debt service coverage of $300,000 in cash available to service debt, a lender is going to be a lot more comfortable.”
Knowing those numbers yourself, before you meet your lender, will give you more confidence when you do go in. That little bit of math will make you more aware of where you’re at and why the bank is looking for certain things, or pushing you in certain directions.
Smith says to really know your numbers, you need to crunch them yourself. There’s nothing wrong working with your accountant to develop those ratios, but most farmers don’t like to pay their accountants to do much more than prepare their income tax.
“If they don’t understand where those numbers came from, it’s not going to do them a lot of good. My advice is, get familiar with your own numbers so you can calculate those simple ratios yourself.”
Cash flow projections
Smith likes to see cash flow projections done monthly, even on a grain farm.
“The best place to start is your income statement. Look at your revenue and expense lines, put them into a spreadsheet, create a column for the total and twelve columns across the spreadsheet – one for each month,” he says.
“If you’re going to have $1.2 million in crop revenues next year, what months do you think that might come in? Work across all your revenue items and expense items across the months. You know when you pay your fertilizer bill, you know roughly how much fuel you need to buy in the spring, summer and fall. Estimate those across.”
“Then I like to add another column for each month and as I go through the year, track the actual to the projected.”
Smith says it’s really hard not to overestimate revenue and underestimate expenses. It’s a skill you need to practice and acquire.
“You need to do it, then revisit the next year for your next projections to fi ne tune it. But this will tell you when you’ll have a cash crunch so you don’t end up in a situation where you have a bill come due, you have to sell some grain and you don’t like the market right now but you don’t have any choice. You have to pay the bill,” he says.
“With a cash flow projection, there’s no surprises, you know when you have to make sales and you can sell into the market when you want to.”
Smith says he doesn’t expect farmers to go back through five years of books to get started. “I would say most guys can do it just from memory. You don’t need to go back a long way. Sit
down in January or February, when you have an idea of how much grain you still have on hand,” he says.
“You’re starting to understand what your cropping program is going to be for the coming year. If you haven’t been doing projections on a monthly basis, start right now and go forward. I wouldn’t spend a lot of time going backwards.”
Without this basic information, Smith says a lender tends to have less confidence. They’ll be more cautions and there might be reluctance to increase operating lines or finance a new piece of equipment. “From my experience on the banking side, it’s pretty easy to be the best in town at this financial stuff. That isn’t an indication that it’s easy to do. It’s
an indication that there’s a lot of guys not doing a very good job,” he says.
“That local banker is your interface with the financial institution you’re dealing with. If they have confidence in you and your knowledge of your numbers, they’ll be able to represent you in a much stronger way to the bank and get you what you need. It makes sense to be known by the local banker as being the best at knowing your numbers.”
How lenders function
Smith says farmer need to understand how their bank works, from the banker’s side of it. It’s just a matter of asking what the credit process is.
“The account manager you’re face to face with is your representative to that bank. He’s going to put your story forward to help get the credit you need approved. He can represent the farmer well if he has confidence in the farmer, the farmer is well prepared, knows his numbers and he’s not going to have any surprises down the road. Bankers hate surprises”.
“You need to understand that the local guy probably doesn’t approve the credit. He makes a recommendation, then someone else takes it apart to analyze it to make a credit decision on it. You need your account manager to have confidence that he can go to his risk manager to push for the deal that you need and represent you, such that you can do what you say you’re going to do.”
Instead of creating a confrontational relationship with your banker where you’re ticked off because he isn’t giving you what you want, understand what he has to go through to get you what you want.
He says front line people now are largely driven by sales. They get their bonus if they get their loan portfolio up. They want to do the deal because they’ll get a bonus if they put more business on the books for the bank.
“There’s somebody else in the bank that will approve whether the bank is prepared to accept that credit risk. You need to understand how that works. How much is he going to push for you if he’s ticked at you because you were ornery with him? You want to create a team type of relationship,” he says.
Another concern Smith has is that farmers often don’t spend enough time explaining their business structure to the lender, which can cause problems. “It sounds simple, because you’re either a sole proprietorship, a partnership or a corporation.
But it isn’t that simple. Seventy percent of farming operations, regardless of business structure, involve multiple owners and operators. That’s important for the banker to understand,” says Smith.
”A farmer may say he’s in partnership with his son, but there’s no partnership agreement. It’s really some form of joint operating agreement. It can get complex really quick. It helps the banker out if the farmer takes the time to explain how the operation works and how it relates to the son, the uncle, the brother and what the wife owns.”
“Those things can hang you out to dry when you take a deal to the credit department and you haven’t got some security set up properly if there are multiple owners.”
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