Managing farm debt

Finding out how best to manage your farm finances

some farmers in Canada have thoroughly looked into optimizing their management of debt, but many need to take a much closer look.

“Farmers need to think about finances more than they have in the past,” says Gwen Paddock, head of agriculture and agribusiness banking at Royal Bank of Canada. “In volatile times, financial management is as important as  production management.”

Farmers are excellent business people, notes David Rinneard, national manager, agriculture at BMO Bank of Montreal, but he says that people who own businesses of any kind have to focus on so many things – a reality that can be hazardous financially. “Farmers have to be vets, mechanics, HR managers, scientists and more,” he notes. “If they make a mistake relating to crop production, it will be noticed in the short-term if not immediately. The thing about financial mistakes is that the effects are sometimes only apparent many months or even years later. That’s why making the right decisions are critical.”

To help you optimize debt management, we’ve assembled some starting points.

  • Understand that total farm risk is a combination of business/operating risk and financial risk. “If you have a high amount of one, you need to have lower of the other,” Paddock says. “Commodity farmers have inherently higher business/operating risk due to the volatility of input costs and output prices.  Grain farmers can reduce this type of risk through the use of hedging, crop insurance, forward contracting and participation in Business Risk Management programs under Growing Forward.”
  • “A sound business plan will help identify opportunities for profitable expansion and how you want to get there,” says Paddock. “Farmers who set goals and business strategies have a much higher rate of success than those who don’t.”
  • Do a return-on-investment analysis on potential new purchases or initiatives. “You should know what impact the investment will have on your bottom line through increased income, reduced expenses or increased productivity,” Paddock notes. “Credit can be easy to get, and some financial institutions only look at whether you can secure and repay the loan. The best use of that loan is another matter.”
  • Understand that how you finance your operation can impact your overall cost of borrowing and ability to expand in the future. “For example, an interest-only loan may be appropriate in the case of a new enterprise that will experience an initial cash flow lag, or in the case of a temporary downturn,” notes Paddock.  However, these loans have floating interest rates and therefore can put the borrower in a precarious position if rates rise – and they are expected to.  Rinneard advises having some loans with fixed interest rates and some with floating rates “to get the best of both worlds,” he says. Paddock recommends matching the type of loan to the asset being purchased; operating loans for operating credit, term loans for machinery and equipment and mortgages for land and buildings.
     
  • Optimize your cash flow. “It can save you money to match repayment of your loans to your income flow,” says Paddock. Also keep in mind that just because you have an annual mortgage payment doesn’t mean you can’t make a payment on the principal at other times. 
  • Find out what criteria your lender is using to calculate the interest rate you pay on your loans. “Lenders will measure and analyze your farm’s performance as part of their risk assessment for your loans,” notes Paddock. “The result of that assessment will determine the risk rating assigned and your cost of borrowing.” That is, knowing what ratios are measured means you can take a look at your ratios and see if there are actions you can take to improve them. “For example, if ‘working capital’ is part of how your bank is calculating your borrowing cost, you should then look at the components of this,” says Paddock. “If you’ve been using your operating loan to buy equipment, this will have negative impact on working capital, so switching to a term loan for this will improve working capital. This may improve the risk rating assigned to your loans, which may in turn decrease the interest being paid on debt.”
     
  • Rinneard advises doing some long-term projections to see what net profits will be three to five years down the road. “Include all variables, including different values for input costs, interest rates and grain prices to see if cash flow remains positive and whether you’re getting adequate returns,” he says. “It may prompt you to rent instead of purchasing equipment, sell off non-productive assets, hire a custom operator for spraying or spreading manure, consider off-farm employment and more.” •