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Credit Concepts You Should Know

Spring is on the way and you may soon be working through the annual credit review process with your bank or perhaps applying for a new equipment loan. A good understanding of some basic credit concepts can help reduce the time, stress and uncertainty involved in arranging the credit you need for your farm.

When staff at your financial institution start in their first lending position — whether personal, business or agricultural lending — they will likely take a training course in the first few weeks that teaches them the five “C”s of credit. These “C”s present, in a straightforward way, what every lender looks at when analyzing a credit application. If you are borrowing money you will be well served by learning them, too. Knowing what the lender is looking for and why will help you provide the information they need and help you understand the background to the questions you may be asked.

The five “C”s are capacity, capital, conditions, collateral and character. Here they are in more detail:

THE “C”S, EXPLAINED

Capacity (or cash flow) is the ability of the farm to meet its debt payments. This something you and the lender should want to know. Capacity is usually looked at from a historical basis and calculated from your financial statements. For new borrowers, the norm is to look at the previous three years’ statements, but when major expansions or changes are involved it will be very useful and perhaps required for you to project the coming year’s income and expense statement to show the expected impact of the expansion or change.

The calculations produce a ratio called debt service coverage ratio. The lender will be looking for some “cushion” for a poor year. In other words, the lender wants to see some additional cash available over and above your total annual interest and principal payments. My recommendation is that you ask your lender about this calculation (and all other aspects of his or her analysis for that matter) so that you understand both how the calculation was done for your farm and how it is being interpreted. That will give you the opportunity to have both a deeper understanding of your financial position and have some meaningful input into the analysis.

Capital refers to how much equity the owners have in the farm. If there is lots of equity, the farm business has more ability to absorb losses when there is a bad year. Lenders also want to see that the business owners have “skin in the game,” although this is not usually an issue with most farm borrowers. For this purpose, capital is usually evaluated using another calculated ratio from your financial statements — the debt to equity ratio. Again my recommendation is that you ask your lender if they calculate this ratio in their analysis and if they did, ask how it compares to what they are looking for.

The third C, Conditions, represents an analysis of other external factors or risks that may impact the farm’s ability to repay its loans. For example, lending to farms in the hog industry these days because of the low or negative returns has more risk than lending to crop farms where returns have been stronger lately. This analysis also deals with what the farmer is doing to mitigate various types of risks to the farm. For example, crop insurance mitigates weather and production risk and forward pricing contracts mitigate market risk. Here’s a tip: Be sure that your lender knows you understand the key risks your farm faces and what you are doing to mitigate those risks.

Most people are familiar with the fourth C, collateral, as it applies in this context. It refers to the assets used as security for a loan. From the lender’s perspective, collateral is simply a secondary source of repayment if the farm runs into financial trouble and can’t make the loan payments. We refer to collateral as a “secondary” repayment source because lenders really don’t want to own these assets and much prefer to see loans repaid as agreed. A major consideration when lenders consider collateral is called margining. Margining is simply discounting the value of security based on historical liquidation values. For operating loans, as an example, lenders may do a margin calculation based on a fixed percentage of the value of assets — such as accounts receivable, inputs on hand and inventory for sale — to make sure they have sufficient security for the loan. My advice in this area is to make sure you understand how your lender is margining your security.

Character is last of the “C”s but may in fact be the most important. This is how the lender views your personal integrity. In other words, is the borrower an honourable person who will act in good faith and intends to meet his or her obligations? This is obviously a tough call for the lender and is based partly on a gut feeling and partly on reputation. Reputation is determined largely by the credit or default history of the farmer. Lenders checks credit history by obtaining a credit report on the farmer personally and perhaps the farm company if there is one. I suggest you ask your lender if they have obtained credit reports on you and, if they have, ask if they will or can share the report with you along with their interpretation. You can also access these reports yourself for a fee. The credit reporting companies in Canada are Equifax (www.equifax.ca)and TransUnion (www.transunion.ca).It is not a bad idea to check these reports every few years to make sure they are accurate.

IN SUMMARY

Another way to think about the five “C”s is that the lender is looking at their risk from two perspectives: first the “risk of default” and second is the “risk of loss in the event of default.” For the lender “risk of default” attempts to answer the question “Can you and will you make the payments?” and is based on an analysis of the farm’s capacity and capital, your industry segment conditions and your character. And “risk of loss” attempts to answers the question, “Will we (the financial institution) lose money on this loan if the borrower doesn’t make the payments?” This is based on evaluating the collateral.

So there you have the 5 “C”s of credit with some insight, tips and advice related to each. It is important to keep in mind that your financial institution is primarily looking at how to manage its risk of lending to you — not your risk of borrowing. Although admittedly there is a lot of overlap and the financial strength of the farm business and the risk factors related to the farm are common to both perspectives, don’t assume that borrowing money for your farm is what you should do just because there is a lender willing to lend it to you!

Earl Smith lives near Sundre, Alta., and does farm and business consulting in the areas of business management, finance and succession. He was previously with RBC Royal Bank where his last position was Manager, Agriculture and Agri-business, Prairies. Contact Earl at 403-586-2504 or [email protected]with questions or comments and for upcoming dates and locations for his Farm Financial Workshops sponsored this winter by Agri-Trend Agrology.

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