Anyone managing the finances on a farm these days knows it takes a lot of cash to put in a crop. Grain farms are unique businesses: they produce one crop per year and often hold a significant inventory of that production waiting for opportunities to deliver and/or sell at an acceptable price. That means you are usually buying or committing to buy the upcoming year’s inputs before you have completely sold last year’s production. And that often means tight cash flow for operating expenses.
If you don’t have enough cash of your own available to pay for input expenses as you buy them what do you do? Well, use someone else’s money of course! That can take several forms — charge accounts and trade credit from retailers and input suppliers, high limit credit cards and operating credit from financial institutions in the form of revolving operating loans, lines of credit or approved overdrafts. Most farms I see are using a combination of these sources. There are a few things worthwhile keeping in mind when using someone else’s money.
CHARGE ACCOUNTS: NOT A GOOD FINANCING OPTION
Although many of the businesses that farmers deal with for fuel, repairs and other inputs allow you to charge on account, this type of credit should not be used for cash flow management except in the very short term. The reason of course is that interest charges usually kick in at a very high rate after the first 30 days. The same is true for most credit cards although some now offer reduced rates. These days many farmers pay for farm inputs with credit cards so they can collect points for travel. That is certainly not a bad thing as long as you pay off the card completely using other operating credit at the end of every month. Both charge accounts and credit cards can be very high cost sources of credit if not managed properly and should be considered a last resort for financing farm inputs.
What I refer to as trade credit is the input financing available from most fertilizer, seed and chemical retailers and grain companies with repayment expected after harvest or the interest clock starts ticking. Interest rates vary but are usually a little to a lot higher than operating credit at your financial institution. Traditionally this credit is underwritten by the credit departments of these companies and is pretty easy to get. As long as you had a decent track record the application process is minimal and approval is usually not an issue.
The credit crisis of 2008-09 seems to have had an impact, as much of this input credit underwriting has now been “out sourced” by many of these companies to financial institutions. What that means is that somewhat more traditional and formal credit application and approval processes have been put in place — you likely need to provide more financial information and sometimes wait for approval. My advice is that if you depend on trade credit for a significant portion of your operating credit needs, get it arranged early so you are not faced with an unwelcome surprise right at seeding time.
TRUE OPERATING LOANS AND LINES OF CREDIT
Revolving operating loans, lines of credit and overdraft lending all serve the same function from the farmer perspective — you have an established credit limit and the amount you borrow goes up and down as you need cash. The idea is to “revolve” the loan to zero at least once a year. If you have experienced losses in the past year (or years) those losses will likely now be part of your operating loan. Lenders refer to the portion of your operating loan that represents past losses and does not revolve as “locked in.”
The advantage of these types of operating credit is that you only pay interest on the money you actually use. If your banking is not set up to have operating loan proceeds automatically advanced into your current account when it is about to be over drawn, it’s usually a good idea to do that. There will likely be a monthly fee involved but you really want to avoid the cost, hassle and potential impact on your credit rating of “NSF” or returned cheques. One thing to be sure you understand though is the minimum increment amount that will be transferred each time a transfer is made.
As an example when your current account is about to be overdrawn by even just a few dollars the banking system may be set to transfer $10,000 to your account from your operating loan. You may be able to reduce your interest cost a bit by negotiating a lower minimum increment, say in this example to $5,000, but just be sure the fees do not change and offset the benefit on the interest charges. Not all financial institutions offer overdraft lending, however, and some people don’t like to see the big negative number on their account statements when they are into an overdraft position.
Be very careful to avoid making capital purchases out of your operating loan. It may be just $20,000 or $30,000 for a smaller piece of equipment and some years you may get away with it but it is not a recommended practice as it frequently is the cause of even tighter cash flows. The preferred approach is to use short term financing for smaller equipment purchases to preserve cash for operations.
Keep in mind that cash flow can be an issue whether last year was profitable or not. It’s important we don’t assume that cash flow won’t be an issue just because last year showed a good profit. And, if you add some expansion into the mix as well, the cash flow gets even tighter. Farm growth really eats operating cash — usually more than we realize until we do the calculations.
Earl Smith lives near Sundre Alberta 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.