Optimal financial structure

When analysing the financial structure of the farming operation, it is important to consider the following:
• The extent of loan capital (debt) relative to the assets (solvability)
• The debt repayment capacity and timing thereof (cash flow)
• The debt burden structures (mix of short, medium and long term debt)
• The extent to which income varies from one year to the next (taking circumstances into account eg: rainfall, drought) and the extent of annual fixed obligations
• Interest rate fluctuations (cost of money)
• Exchange rate change (if product exported)

Theoretically, the optimal financial structure is a level where the farmer can regularly meet both short and long term debt obligations by employing borrowed funds profitably in the business by obtaining the right combination of short, medium and long term debt. Ultimately more should be earned from the loan capital than the costs associated with it. The optimal financial structure will vary from one farm to the next, from one type of farming activity to the next and from one region to the next.

No optimal long term financial structure can be prescribed – this should be revisited annually as circumstances (yield, prices, interest rate changes etc) change. The greater the fluctuations in income, the greater the ratio of assets to liabilities should be in a farming business.

Financing should be structured in such a way that the combination of short, medium and long term debt will enable all interest and repayment obligations to be met in both ‘good’ and ‘bad’ years.

The farmer should try to create credit reserves. If only a part of the approved facility is used (eg: 75%) the unused portion (25%) will provide a cushion which will enhance the farmer’s flexibility, provide breathing space and reduce financial risks.

Sound financial management
Sound cash management should ensure that sufficient income should be generated to meet operating expenditure, interest and capital obligations. Extent of loan capital should be consistent with repayment and cash capacities of the farming venture. The farmer may be credit worthy according to the balance sheet, but repayment capability must be determined from the income statement and cash flow statements.

Due to unforeseen circumstances (eg: crop not yet harvested), obligations may not be met on the due date despite repayment capacity, and actual cash flow will have to be taken into account to determine new instalments/dates or reducing payments.

The higher the level of risk and uncertainty in a farming enterprise, the lower the level of loan funding to be employed in the business. The known risks should be factored into the planning and continually evaluated to determine strategies to overcome them as well as to ensure repayment of the debt obligations.

Knowledge of the capital needs of the business
The farmer’s needs for future funds can be determined from the nature of historical and current capital needs, taking into account any change in circumstances as well as risks and uncertainties. Needs can be assessed through the use of the farmer’s Balance Sheet, Income Statement and Cash Flow Budget. Any changes in personal circumstances, production capacities, enterprises, mechanisation, interest rates etc should be taken into account.

Before making a final decision on credit/ borrowings, one should carefully consider how the loan funding is going to be utilised. The right funding should be used for the right purpose:
• Short Term: 0-1 year (overdraft, production loans)
• Medium Term: 2-5 years, may be up to 10 years (ISAs, rental agreements)
• Long Term: 10 years and longer (long term bank loans)

Short-term credit
• Short term credit required to finance production and consumer goods.
• Short term credit is generally required as the farmer needs to cover the costs incurred over the production term and income may only be received periodically.
• Operating capital required for rations, wages, seed, bags, fodder, rental etc.

Medium-term credit
• Generally required for purchases of machinery, breeding stock, soil preparation, planting of trees etc.
• The considerations for medium term credit and the repayment conditions is mainly the useful life of the asset being financed

Long-term credit
• Used for the purchase of land, fixed or permanent improvements and refinancing existing debt (debt consolidation)
• Security normally provided by a mortgage over fixed property
• Where improvements are being financed, the necessity, durability and profitability of such improvements should be considered and the payment term should be the useful life of the asset.

To conclude, the aim of using loan capital is to eventually increase the profitability of own capital in the business. When loan capital is required to finance any shortfall in income, the finance structures should be reviewed. The restructuring of loans has helped farming operations in the past to improve cash flow and to create equity for future expansions.

By Deon van Wyk, ABSA Regional AgriBusiness Manager (email: deonvw@absa.co.za)

*First published in SA Forestry magazine, July 2019

Related article: Determining the financial position of a farming operation