How Does Your Lender View You and Your Financial Statements?

By Coralee Foster & Neil Van Oirschot

September 02, 2010

The relationship between a farmer and their lender is critical to the success of the farm operation. However, many farmers are unsure of exactly what information their lender is looking for and what will impact their borrowing arrangements.

Collateral

Collateral, or the presence of assets sufficient to secure any borrowings, can be comprised of land, buildings, equipment, quota or personal assets of the borrowers. Generally, real estate is easy to provide as collateral and lenders will prefer this over any other form. Real estate generally increases in value and cannot be moved, providing good security for a lender, should they need to collect on the collateral to satisfy their loans.

Quota can present a challenge as far as security for loans. While it historically has increased in value, the uncertainty surrounding its future precludes most lenders from accepting the full amount as security for loans. Typically lenders will loan 50 to 70% of the value.

Lenders may wish to secure additional coverage by using loan postponements where there is significant debt to related parties. This ensures that the operation’s ability to pay off bank debt is not impaired by repayment of other loans.

Borrowers are also often asked to provide personal guarantees, in addition to the direct security provided. This is not uncommon and is a mechanism to provide recourse to the principals of an incorporated farm operation or in some cases a guarantee is required when the tangible security provided is owned by entities other than the borrower.

Cash Flow

While it is important to have adequate security for lenders to access should the loans go into default that is not how either lenders or farmers wish to satisfy borrowing obligations. The operation must be able to generate sufficient cash flow to finance the principal and interest repayments. Cash flows from operations must also provide adequate funds for the farm family to meet their living needs; many producers underestimate what that amount is.

Lenders will often refer to many calculations to determine the amount of cash flow available to service debt. Depending on the commodity being produced, most lenders will look for debt servicing capacity of 1.10 to 1.25 times the expected annual repayments of principal and interest.

Character

In addition to the financial criteria, it is important for your lender to be able to assess your ability to manage the farm operation and your commitment to success. While many farmers have had ongoing relationships with their lenders for years, those just starting out may have difficulty demonstrating this. For that reason, it is important that as a new generation takes over the management of the farm that they be integrated gradually into that role. They should be involved in the regular meetings with the lenders, accountants and other advisors to begin supplementing the technical knowledge that they possess about the operation with an understanding of the administrative matters.

Financial Statements

It is important to have good accounting records for a variety of reasons – making management decisions, filing tax returns, estate and succession planning and presenting to your lender.

Most farms file their tax returns on a cash basis. While this is often favourable for tax purposes, it does not provide as accurate financial results as accrual financial statements do. Accrual financial statements will consider the value of inventory, accounts receivable, accounts payable and prepaid expenses and provide a better indicator of the profitability of the operation. Many lenders will insist upon full financial statements for that reason. While there may be an added cost to have them prepared, the value can easily be recovered with more favourable lending arrangements and an improved ability to accurately assess the viability of the farm.

Accrual financial statements can then be converted to a cash basis for income tax filing purposes.

Conclusion

It is important that farmers understand the need for all of these factors to be solid. Providing good information to support your management abilities along with adequate financial records will help your lender understand your business and help you maximize the benefits from your borrowing relationship.