Farm Finance: Rural America - American business

The process of acquiring and using capital in agriculture. This article addresses the sources of financing used by farmers: equity and debt funds. It examines several of the ways credit is used in the farm business and some of the investment decisions farm operators must make.

Sources of Financing

Any decision to expand or reorganize the farm business must involve an evaluation of the alternative means to obtain the capital resources. A farm operation requires two types of capital: investment capital and operating capital. Investment capital includes such items as machinery, equipment, land and other durable inputs, whereas operating capital includes seed, chemicals, fertilizer and other inventories and supplies.

The funds required to finance the investment and operating capital requirements of the farm business can be obtained from many sources but usually are classified into two basic categories: equity funds and debt funds. Equity funds are supplied by the owner(s) of the farm operation; they provide the backbone of any financing arrangement. Some people refer to equity funds as risk capital because, in the event of liquidation of the business, the holder of equity funds has the residual (last) claim on the liquidation proceeds after all other claims have been satisfied. Consequently, the equity capital bears the risk of any financial loss, and it also reaps the benefits of any profits or financial gains. In contrast, debt funds are provided by financial institutions or individuals with no ownership interest in the farm business. Debt funds usually carry a cash cost in the form of interest and have a first claim on net income or proceeds from liquidation.

A third method that can be used to gain control of investment capital items is that of renting or leasing. Operating leases are short-term, seasonal leasing arrangements whereby the lessee leases the equipment for a specified number of hours, days or on a per-acre basis. Custom hiring is one form of an operating lease. In recent years, capital leases that involve a longer time commitment (such as three to five years) have become more popular for some machinery, equipment and facility purchases. Renting or leasing a capital item such as machinery or land reduces the investment capital commitment of the farm operator, but it typically increases the cash flow and operating capital requirements.

Equity Sources of Funds. Since equity is the financial backbone of any business, acquiring or accumulating equity funds is essential for the successful farm operator. A farmer can accumulate equity through savings, or acquire it through inheritance or marriage and other family arrangements. Alternatively, the farm operator may combine her or his equity capital with that of an outside investor or a family member, such as parents or a sibling in some form of pooling arrangement to obtain a larger equity base, which then can be used to increase the size of the business and improve its efficiency through economies of size.

The most important source of equity funds is savings. Savings is the amount of income that is not consumed and is thus available for reinvestment in the farm business. The volume of savings can be increased not only by increasing farm income, but also by reducing family expenditures and taxes. In many farm businesses, the primary method to increase equity capital accumulation is through reduced consumption, particularly for young farmers. Another method to increase equity capital accumulation through savings is to obtain off-farm employment with the earnings being substituted for farm income to meet consumption requirements.

Savings provides more than just equity funds that can be used to purchase assets. Savings indicates an ability to handle one?s finances which will have an impact on the amount of credit or debt that can be obtained. It also indicates a willingness to forgo current consumption for the benefit of a higher level of income and standard of living in the future. Historically, farmers have had a higher savings rate than most people. Analysts have estimated that farmers save almost onethird of their income; that is, approximately one-third of their disposable income is reinvested in their farming operation.

A second important source of equity funds for many businesses is that of inheritances or gifts. For many young farm operators, accumulated savings will not provide an adequate financial base for a viable farm operation with the potential for growth and expansion. One common way to augment savings is through gifts received from relatives and inheritances from the parents. In most cases, accumulating equity funds through gifts and inheritances is part of an overall intergenerational transfer plan that has been developed to transfer the farm business as a going economic concern from the parents to the on-farm operating heir. In these situations, the operating heir typically has been active in the business for a number of years, and his or her acquisition of the farm at the death of the parents is a natural step in the transfer plan.

A third source of equity funds for the farm business is that of the investor, whether he or she is a doctor, lawyer, farmer or widow of a farmer. Combining resources with an investor may not directly increase the equity funds of the farm operator, but it does increase the capital base and the size of the business available to manage. This increased size of operation may result in increased efficiency because of economies of size, and thus increase the income-generating capacity of the business and the accumulation of equity over time through increased savings. Thus, the benefits to the farm operator of using someone else?s equity funds are primarily those of economies of size and future equity accumulation. In addition, the investor may be the only source of additional equity funds for beginning farmers who have no family members with sufficient resources to assist them in obtaining the critical mass of capital necessary to begin farming. The investor also may play an important role in providing capital to agriculture through the rental market. This contribution occurs through the rental of real estate to operators who may not have adequate resources to purchase a similar tract of land.

Debt Sources of Funds. Although equity funds provide the financial backbone of any farm business, most farmers do not generate sufficient equity from savings or other sources to expand as rapidly as they desire. Thus, they are forced to use additional sources of funds in the form of debt or credit to expand their operations.

Farmers are served by a three-pronged credit market: the private sector, the cooperative sector, and government agencies. The private sector consists of such firms as commercial banks, merchants and dealers, insurance companies, finance companies, and individuals who make personal loans to farmers. For the most part, these financial institutions have been a dependable source of operating and investment capital for farmers and in many cases have developed specific lending programs for agricultural producers.

Although the private sector historically has been an important source of credit for farmers, at times it has had difficulty servicing agriculture because of the higher rates of interest that could be obtained making loans to nonagricultural businesses and because of the limited supply of funds that could be mobilized to loan to farm firms. Consequently, the cooperative credit system was developed to enable farmers, through a cooperative effort, to tap the national money markets. The cooperative credit system comprises the banks and associations of the Farm Credit System. The banks obtain funds by selling bonds on the national money markets to investors. The proceeds of the bond sales are then loaned to farmers or to grain merchandising or input supply cooperatives. The entities of the Farm Credit System function as cooperatives and are owned and managed by the users of the System. The Farm Credit System has not only increased the availability of funds to farmers through access to national money markets, but it has provided many new innovations in agricultural lending and stimulated the private sector to provide more efficient service to farmers.

The third component of the agricultural credit market includes the government agencies. The federal government provides funds to farmers through the Farm Services Agency (FSA) under two programs best known by their previous names: the Farmers Home Administration (FmHA) program and the Commodity Credit Corporation (CCC) program. In some states, state agencies also make loans to farmers, particularly beginning farmers. The primary purpose of the FSAFmHA program is to provide loans to farmers who cannot obtain funds from either the private or cooperative sector. Consequently, the program provides funds for disaster situations and when risks are too high for the private or cooperative credit institutions. FSA-CCC loans are part of the income and price support program of the USDA. This program provides loans for grain storage as well as a combined operating loan-income support program to augment farmers? incomes by accepting the commodity as payment in full on the loan if commodity prices are below the loan value.

Use of Credit in the Farm Business

Credit is an important and necessary resource in nearly all commercial farm businesses. Credit is a somewhat unique resource in that it provides the opportunity to pay for the cost of using additional inputs and capital items now from future earnings. Hence, the potential improvement in net farm income should be the determining factor in deciding whether or not to use credit in the farm business.

Credit can contribute to the improvement of net income of a farm operation in several ways. First, it can create and maintain an adequate size business. In most farm operations, this means expanding the operation to obtain an acceptable level of income and to take advantage of economies of size. Credit can play an important role in acquiring the investment capital to expand the business as well as to acquire operating inputs to maintain a high volume of output.

Second, credit can increase the efficiency of the farm business. The use of credit may make it possible to substitute one resource for another (such as machinery for labor) as a means to reduce cost, improve timeliness, and increase the efficiency of the farm business. Credit may be essential to increase the intensity of production with present resources by using increased quantities of fertilizer and chemicals, better breeding stock, or more efficient machinery to improve the timeliness of crop production.

Third, credit can adjust the business to changing economic conditions. New technological developments or changing market conditions can make it essential to make major changes in the farm business. For example, adopting confinement hog production technology or acquiring conservation tillage, or larger planting, harvesting or power equipment may be essential to maintain efficiency as prices decline and costs increase. Credit is a major resource that can be used to assist in making these adjustments and changes.

Fourth, credit can help farmers meet seasonal and annual fluctuations in income and expenditures. Most farm operations have wide seasonal and annual fluctuations in expenditures and incomes. Cash inflows and outflows typically do not occur at the same time of the year, and cash deficits frequently occur from the planting to harvesting seasons. Using credit to match cash inflows and outflows is essential to efficient operation of the farm business if large cash reserves are not available.

Fifth, credit protects the business against adverse conditions. Weather, disease and price are all uncertainties in the farm business. Good management can reduce the risk, but it is extremely difficult to eliminate all risks in farming. Credit can play a major role in protecting the farm business from financial failure or liquidation when adverse conditions occur. Maintaining some credit in reserve that can be used in situations such as an equity margin in real estate that can be used for refinancing short-term obligations may be an important method of protecting the farm business from unpredictable risks. Liability management or managing the structure and amount of the liabilities of the farm business may be as important as asset management (diversification, flexible facilities, etc.) to protect the farm business against the adverse financial consequences associated with risk.

And sixth, credit provides continuity of the farm business. The transfer of an ongoing farm business from one proprietor to another involves large quantities of capital. Without credit, many farm businesses would have to be liquidated during the transfer process because nonfarm heirs frequently want their inheritance in cash and do not want to maintain ownership of farm real estate and other assets. In most cases, credit is essential for the successful intergenerational transfer of the business because the tax liability and claims by offfarm heirs erode the equity capital base, and either assets must be sold or credit used to substitute for the equity that has been lost in the transfer process.

Safe use of borrowed money is extremely important in the successful farm business. The credit-worthiness of any farm depends on the risk-bearing ability of the operation, the returns that can be generated in the business, and the repayment capacity of the operation. Furthermore, farmers should be aware of the legal documents involved in borrowing money, including the promissory note, the mortgage or security agreement and financing statement, and the installment contract. In addition, a farmer should be aware of the obligations he or she faces upon default, including foreclosure and bankruptcy procedures.

Investment Decisions

Capital investment decisions that involve the purchase of durable inputs, such as land, machinery, buildings or equipment, are among the most important decisions undertaken by the farm manager. These decisions typically involve the commitment of large sums of money, and they will affect the farm operation over many years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time. Because the benefits are based on future events and the ability to foresee the future is imperfect, considerable effort should be made to evaluate investment alternatives as thoroughly as possible. This evaluation may include analysis of the decision under alternative futures with respect to prices, productivity and cost, for once the decision is made and an alternative is chosen, the direction and operation of the firm will be affected for a number of years.

Most capital investment projects can be classified as either output increasing or cost reducing. Investments such as new buildings, additional land and more livestock generally are acquired to increase the volume of business. It is hoped that the added revenues will exceed added costs and that net profits will increase. In contrast, most machinery is acquired to replace manual labor or worn-out items, the repair costs of which are expected to be excessive. Thus, machinery has the general effect of reducing labor or repair costs without necessarily changing total output. Some investments will fall into both categories; that is, they may simultaneously increase output and reduce production costs. Some investments are neither output increasing nor cost reducing but nevertheless must be made. For example, the owner of a large livestock operation may be required to invest in a new waste disposal system to comply with pollution control regulations. Although these types of forced investments must be made, a careful analysis is still needed to determine the particular type of system that should be installed.

There are four major steps involved in the evaluation of capital expenditure proposals. First, identify all possible profitable investment opportunities. This step should be taken to insure that the most profitable?not just a profitable?investment is chosen. Second, evaluate the economic profitability and financial feasibility of the various investment opportunities. Evaluating economic profitability involves determining the capital outlay required for each alternative and the earnings or benefits that will likely result from each alternative, and comparing the outlay to the benefit stream. Financial feasibility involves a comparison of the cash inflows generated by the investment project with the principal and interest payments that are due on any borrowed funds used to purchase the capital item. Third, reevaluate the decision under different price and yield assumptions. Since the investment decision involves projections into the future and a major commitment over time, it is desirable to evaluate the economic profitability and financial feasibility of an investment alternative under different sets of future prices and productivity. And fourth, choose an alternative based on the economic and financial evaluation as well as other factors that would influence the investment decision. As with any managerial decision, judgment must be combined with the economic analysis to select an alternative.

? Michael Boehlje

See also

• Agricultural and Applied Economics; Banking Practices; Financial Intermediaries; Foreclosure and Bankruptcy; Policy, Agricultural

References

• Barnard, Freddie and Michael Boehlje. ?Evaluating Financial Position, Performance, and Repayment Capacity for Agricultural Businesses.? Journal of the American Society of Farm Managers and Rural Appraisers (1995): 73-79.
• Barnard, Freddie and Michael Boehlje. ?Using Farm Financial Standards Council Recommendations in the Profitability Linkage Model: The ROA Dilemma.? Journal of the American Society of Farm Managers and Rural Appraisers, pp.7-11, 2004.
• Barry, Peter J., Paul N. Ellinger, C.B. Baker, and John A. Hopkin. Financial Management in Agriculture. 6th ed. Danville, IL: Interstate Publishers, Inc., 2000.
• Boehlje, Michael. ?Evaluating Farm Financial Performance.? Journal of the American Society of Farm Managers and Rural Appraisers 58, no. 1, (June 1994): 109-115.
• Brake, John R., and Emanuel Melichar. ?Agricultural Finance and Capital Markets.? Pp. 416-494 in A Survey of Agricultural Economics Literature, Volume I: Traditional Fields of Agricultural Economics, 1940s to 1970s. Edited by Lee R. Martin. Minneapolis, MN: University of Minnesota Press, 1977.
• Harl, Neil E. The Farm Debt Crisis of the 1980s. Ames, IA: Iowa State University Press, 1990. Hughes, Dean W., Stephen C. Gabriel, Peter J. Barry, and Michael D. Boehlje. Financing the Agricultural Sector. Boulder, CO: Westview Press, 1986.
• Lee, Warren F., Michael D. Boehlje, Aaron G. Nelson, and William G. Murray. Agricultural Finance. 8th ed. Ames, IA: Iowa State University Press, 1988.
• van Horne, James C. Financial Management and Policy. 12th ed. Englewood Cliffs, NJ: Prentice-Hall, Inc., 2001.
• Weston, J. Fred and Eugene F. Brigham. Essentials of Managerial Finance. 13th ed. Harcourt College Publication, 2004.
• Wilson, Christine, Freddie Barnard and Michael Boehlje. ?A Financial Analysis Program That Will PASS the Farm Manager ?Interest Test.?? American Society of Farm Managers and Rural Appraisers (ASFMRA), 2007.

Source: http://american-business.org/3383-farm-finance-rural-america.html

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