If the loan is for an unprofitable investment, there is no point in using credit, or in making the investment, for that matter. If there are indications that loan repayment will break down, the loan should not be made. Therefore, you should project your debt-repayment capacity before borrowing.
Debt-Repayment Capacity
Repayment capacity is the ability to meet loan payments as scheduled. Two factors are involved: 1) the amount of funds available to pay debt obligations, and 2) the terms of repayment. Projecting repayment capacity must be considered in terms of all of the income and expenses expected during the period of the loan. While it is expected that conditions will vary, the best one can do is to make projections based on average yields, costs and prices expected.
What funds are available to pay debt obligations? A farm business generates a net cash income, cash receipts less cash operating expenses. This net cash income is what the operator has available to pay personal wants and obligations, such as living expenses, personal taxes, debt obligations, capital expansion and savings. Obviously, the operator has priorities on how the net income will be spent. Living expenses and taxes have a high priority; therefore, allowances should be made for these before determining what is available for principal payments.
Loans for operating expenses such as feed, seed, chemicals, fertilizers and feeder livestock should be considered as current operating expenses. These are considered self-liquidating loans because they are directly related to current production and are used up in the production of specified products. They should be repaid when the product they produce is sold.
Repayment of loans that finance machinery and breeding livestock (assets with a productive life extending over a number of years) can be extended for several years. Because the amount of depreciation on this class of assets varies yearly and the expected life is uncertain, it is a sound business practice to retire the debt on these assets before the useful life of the asset is expended. Planning accordingly will improve your chances for success.
Repayment of loans on facilities, such as buildings with productive lives of 10 to 20 years, can have longer repayment periods than for machinery. However, because of the possibility of obsolescence or unforeseen loss, it is sound policy to have repayment at less than the expected useful life. In fact, many lending agencies finance only for a fraction of the expected useful life.
Funds used for operating expenses and original capital investment for items that depreciate are in effect returned to the operator as part of marketing output. However, funds used to buy assets that do not depreciate, such as productive land, continue to be tied up until the asset is sold. The returns to this asset are thought of as rental or interest on investment, and the original capital is partially returned through gross income each year. Therefore, repayment of loans on assets that do not depreciate should be considered as part of the annual cost of production. Because certain expenses, such as living expenses and taxes, have a high priority on net income, they must be considered before determining the amount available for principal payments.
The second factor, terms of repayment, is a conditional factor that determines the debt load that can be safely carried. These repayment terms are set at the time the loan agreement is signed. When an agreement is not involved, the terms of the loan are set by the customary credit policy of the lender or input supplier granting credit. For example, open accounts may be due by the 10th of the month; thereafter, an interest charge (such as one percent per month) may be charged. The length of time over which the loan is to be repaid and the amount to be paid periodically are the final determinants in the repayment capacity. Generally, the purchaser is billed at the end of the month. For certain supplies, such as oil, seed and fertilizer, the dealer may have 90-day accounts or accounts due after the harvest of a crop produced by the inputs.
Intermediate-length loans for livestock and machinery vary from two to as many as seven years or more in length. Many are installment-type loans, set up on equal regular payments to include interest and principal. This arrangement may be satisfactory for farmers with regular receipts, such as dairy farmers. However, farmers producing crops and meat animals find it more satisfactory to have loan repayment on a less regular basis, usually timed to the sale of crops and livestock.
Budgeted loans, a form of line of credit, are increasing in agriculture. The lender and borrower determine in advance when loan funds will be needed and the timing for repayment. Funds are then advanced as needed and repaid as products are sold. This type of loan gives flexibility in managing cash flow, and the borrower pays only for the money actually used.
Repayment
The most commonly used methods of repaying long-term loans are the straight-end payment, partial payment and amortization.
The straight-end payment calls for regular payment of interest with the entire principal paid at the expiration of the loan. This method may allow you to carry a higher debt load, but it can also place you in an awkward situation when the loan expires. You must make provisions to have funds available for the principal when it comes due.
Partial-payment loans require small, fixed principal payments each. During the life of the loan. These payments do not liquidate the principal during this repayment process, hence a fairly large amount, a "balloon" payment, is due at the end of the loan term to finish paying principal. This type permits a larger debt load during the loan life with some additional risk at loan termination. Provisions must be made to have the balance available at loan termination or an extension of the loan period will be needed.
Amortization of long-term loans is being used more and more in agriculture. Two amortization plans are used: reducing-payment and even-payment. The reducing-payment plan has equal principal payments each year and interest payments that decrease as the loan repayment progresses. Annual payments thus decrease as the loan repayment progresses. The even-payment plan provides for fixed, equal payments that cover principal and interest. During the early years of the loan, a larger proportion of the payment goes for interest; during the latter years, a larger proportion to principal.
The debt load carried by amortization plans can be increased by extending the loan over more years. On real estate loans, it is sometimes advisable to set the repayment period over more years than the anticipated minimum number required for repayment if cash flow projections show any potential problems. This provides for fluctuation in income as well as some flexibility in meeting additional operating expenses during the repayment period. It's always possible to repay the note early or change the terms if you are a good customer. Remember to keep the loan life less than the asset life.
As indicated earlier, the repayment capacity of a business is its ability to meet loan payments as scheduled. Therefore, the amount of debt a farm can carry is determined by 1) funds available to pay debt obligations and 2) terms of repayment. Financially successful farm businesses have a residual of net cash income over cash operating expenses. In the usual farm accounting methods, this is what the farmer uses for such things as family living expenses, personal taxes and insurance, loan repayments, capital purchases, savings and investments. Interest on debt is usually considered an annual operating expense; therefore, the net cash income will be reduced by interest payments.
The actual funds remaining for loan principal payments out of the net cash income will be the result of the family's priority for other expenditures. Obviously, family living expenses have a high priority; other wants and expenditures may or may not have less demand on income or can be delayed. Nonetheless, allowances must be made for all expenditures the farm and the family will make before designating what will be available for loan payments. Table 1 illustrates the funds available for loan payments in a sample farm business.
Table 1: Example funds available in a Farm Business
1. Cash Farm Income (livestock and products, crop sales,
custom work, government payments, miscellaneous) $64,000
2. Cash Farm Expenses (labor, feed, crop supplies, fertilizer,
lime, repairs, fuel, utilities, livestock supplies, real estate,
taxes, insurance, interest payments [$3,000], etc.) $46,000
3. Net Cash Income (1 minus 2) $18,000
4. Family Living Expenses and Personal Priorities (food,
clothing, medical, utilities, transportation, contributions,
taxes, insurance, recreations, etc.) $12,000
5. Funds Available for Loan Repayment from the Business $ 6,000
(3 minus 4)
The $6,000 (line 5) represents the amount available for principal payments. As illustrated (line 2), $3,000 was included under Cash Farm Expenses for interest payments. Many repayment loan schedules, such as for installment type loans or amortized loans, are set up to cover both interest and principal in equal payments over the life of the loan. To project the repayment capacity of the business with these types of the loans, the interest paid is added to the $6,000 in the above illustration for a total of $9,000. This example assumes no outside income to help defray living expenses; the objective is to determine the debt carrying capacity of a farm business.
Table 2: How Loan Terms Impact Loan to be Carried
Years for
Repayment Interest Rates
8% 10% 12%
2 $16,049 $15,620 $15,210
5 35,934 34,117 32,443
10 60,391 55,300 50,853
20 88,365 76,622 67,224
25 96,072 81,692 70,588
Now consider the effect of the terms of the loan on the debt load that can be carried by a business. The two major factors are the term (years for repayment) and the interest rate. Extending the term increases the debt load that can be carried; increasing the interest rate decreases the debt load that can be carried. For example, the $9,000 available for interest and principal payments in the previous example could carry any of the debt loads shown in Table 2 amortized by annual payments.
In many farm situations, the debt structure is a combination of different loans for operating expenses, cattle, machinery, buildings and real estate. The result is a combination of short- (one to two years), intermediate- (two to seven years), and long-term loans. Once repayment schedules become fixed, there is little flexibility in increasing the debt load with a fixed amount available for debt financing. To finance additional loans, net income must be increased by borrowing only when the loan will: 1) increase net income, 2) increase financial and operational efficiency (reduce expenses, increase volume, higher prices), and 3) reduce nonfarm expenditures. In some situations, equity in real estate makes it possible.
