by Michael Langemeier
There are numerous sources of risk in production agriculture. Sources of risk can be summarized using five broad categories: production and technical, price and market, financial, legal, and personal. In this article, managing financial risk through the use of credit reserves will be briefly discussed.
Financial risk is incurred when a farm borrows money to purchase assets or operate the farm. Financial risk is caused by uncertainty pertaining to interest rates, lending relationships, changes in market value of assets used as collateral, and cash flow used to repay debt. Financial risk is often inter-related with other sources of risk, particularly production and technical, and price and market risk. For instance, when production and/or prices are relatively low, a farm is going to have more difficulty repaying loans and the market value of assets is likely going to soften and perhaps even decline in value.
Managing financial risk is an extremely broad topic. Sub-topics would include managing capital structure (i.e., mix of debt and equity capital), examining the relationship between financial leverage and risk, using credit reserves, liquidation costs or converting risky assets to cash, using self-liquidating loans, and managing changes in interest rates. The discussion below focuses on credit reserves.
Establishing solid relations with lenders is a key factor in managing financial risk. These relationships may allow borrowers to carry over loans, defer payments, refinance loans, and use credit during times of financial stress. Credit reserves (i.e., unused borrowing capacity) are also more likely to be available to clients that have a solid relationship with their lenders.
Credit reserves are particularly important during times of low net returns or cash shortfalls. When net returns are low, particularly for multiple years in a row; liquidity in the form of cash, supplies, and grain inventories typically declines. Rather than completely liquidating current assets, the business may be able to use credit reserves to help meet short-term obligations.
Let’s use an example to illustrate the use of credit reserves. Assume that a farm has a formal line of credit of $250,000. If the farm borrows $250,000; the credit reserve will be zero, and there is no cushion to cover future shortfalls. However, if the farm only borrows up to $200,000 during the year; there are credit reserves of at least $50,000. These credit reserves could be used to cover a future shortfall of $50,000. If the cash shortfall is greater than $50,000; the farm will need to borrow additional funds or perhaps liquidate current assets such as grain inventories to meet the amount above $50,000.
This article described the importance of credit reserves (i.e., unused borrowing capacity). These reserves can be used as a source of liquidity during extended periods of low net returns. Using credit reserves can prevent having to liquidate crop or livestock inventories in times of low prices. In other words, these credit reserves may increase the farm’s flexibility in dealing with liquidity problems or financial stress. Next month’s article will discuss the use of Du Pont financial analysis to examine the impact of a change in revenue, variable costs, or leasing arrangements.
