Years ago, there was a basketball book about the famous coach Bob Knight called Season on the Brink. With that title in mind, let's examine a recent question from an agricultural lender. “I am mentoring a new lender concerning a customer who is struggling financially. At what point is it better to stop lending more money rather than letting the customer burn through their financial liquidity and equity? Is it up to the lender or the borrower? Some people just keep digging a deeper hole with no end in sight or regard for the equity earned over the years. Any suggestions for a customer on the financial brink?”
To illustrate the assessment process in an objective manner, let’s consider an actual case study of a struggling producer. This particular farm was quite profitable during the commodity super cycle from 2008 to 2013. The farm’s financial ratios including debt service coverage, working capital to expenses, operating expenses to revenue, return on assets (ROA), and debt to assets were strong. However, fast-forward to the recent economic reset and the same ratios headed south financially.
In this case, the producer has negative working capital and would be required to use land and other excess equity as collateral to restructure debt to generate working capital to maintain day-to-day operations.
The land and buildings were valued at $4 million with $2 million of term debt. Much of the existing term debt was related to previous refinances. In this instance, the lender had an advance rate, or the maximum amount they would extend on real estate, of 75 percent to ascertain the borrowing capacity. Thus, $4 million times 75 percent equals $3 million of total term debt. When considering the $2 million of existing term debt, the farm had $1 million of borrowing reserve. In this case, the producer’s most recent annual loss was $625,000. To calculate the burn rate, divide $625,000 into the $1 million. This yields a burn rate of 1.6 years if losses were not curtailed.
Utilizing the above scenario, if land values declined 20 percent the outcome illustrates dire straits. The total real estate value would fall from $4 million to $3.2 million. The lender’s advance rate of 75 percent remains unchanged, but the borrowing capacity is reduced to $2.4 million. With the existing term debt, the borrowing reserve decreases to $400,000. Divide the current losses of $625,000 into $400,000 and the burn rate drops to less than eight months. This business is on the financial brink!
In the case illustrated above, the lender needs to objectively present the scenarios and allow a few days for the business owners and family to “digest” the material. All family members and business partners need to be present. During this discussion, some other items that may need to be considered are as follows:
- What are the short and long-term goals of the family members and partners?
- If the farm is the retirement plan, what are the implications for the senior generation in their golden years?
- What is the opinion of the junior generation concerning the sweat equity they have in the business?
- Is there a reasonable written plan with an execution and monitoring assessment to reduce the $625,000 of annual losses?
- What are the options for the owners, managers, and employees involved in the business?
- How will the additional loans be classified by the lender and influence loan structure, loan covenants, interest rates, and regulator viewpoints?
- Will there be any deferred tax issues as a result of the decisions made?
In conclusion, this is a classic example of the bridge to pier concept. Will the refinance request provide enough economic bridge? If corrective action is insufficient will it result in the business going out to the end of the pier where the water is deeper, thereby increasing the probability of drowning in debt?
In working with farmers over the years utilizing this objective assessment process, they will usually make the tough decision or drastically alter the situation, reducing the stress on the lender and stopping the producer from digging a deeper financial hole.
Source: Dr. David Kohl, which is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.