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Give Yourself Credit for Knowing

Posted Apr. 30, 2003

Most farming and ranching businesses have debt. With the current level of interest rates, an astute business person should spend time "shopping for credit" to save on interest expense. The terms of a loan agreement are as important as which lending agency lends the money. Typically, a lender will consider some basic credit factors when considering whether a loan will be made to a potential borrower.

The factors are called the 5 Credit Factors:

  1. capital
  2. capacity
  3. collateral
  4. character
  5. conditions.

Let's look into more depth for each of these credit factors.

Capital refers to the current financial condition and past financial progress. Reviewing the balance sheet will reveal the amount of borrowed versus equity capital. Balance sheets from several years can inform the lender of the trends for liquidity and solvency. Several financial ratios are calculated to evaluate the historical financial performance. Another element of the capital factor is the lender reviewing the market values associated with the assets. In addition to market value, several other questions should be asked about the collateral. Is it identifiable? In saleable condition? Is it possible to estimate a value? Does the collateral perish? These are some questions the lender should ask to determine the potential risks associated with the collateral listed in the loan application.

Capacity refers to repayment capacity. The loan officer examines both the historical and projected profitability and cash flow of the business. The projected change in net worth (cost basis) is another important number evaluated by the lending entity. Net worth is expected to grow each year in businesses that are prospering . In the long term, the business must have sufficient operating margins to cover occasional operating losses and unforeseen capital expenditures. Ask yourself, "Will sufficient repayment reserves be available if there is a shortfall in earnings?"

Collateral is the final source of repayment to the lender if the borrower defaults on the terms of the loan agreement. This is the lender's ultimate protection against a borrower?s ability to pay. Lending agencies prefer not to own the assets purchased by the borrower. Lenders lend money and if they preferred to own farm and ranch assets they would buy them directly. They are in the business of lending money. The relative liquidation value, location and the availability of additional collateral are important issues both parties need to discuss prior to signing the loan agreement.

Character is also referred to as the credit "human factor." It relates to the integrity of the borrower and their ability to manage a farm and ranch business successfully. The manager's risk attitude is an important element of the human factor in acquiring borrowed funds. The importance of character cannot be understated. A negative evaluation in this factor will normally lead to loan rejection even if the other four factors are very good.

Conditions of a loan refers to the purpose of the loan and the terms listed by the lender. The loan amount, use of funds by the borrower, and the repayment terms are part of the conditions factor. The borrower must evaluate the appropriateness of the restrictive conditions of the loan document.

These are the 5 C's for determining the qualifications for obtaining credit. Farmers and ranchers have a great opportunity to refinance existing debt given the current level of interest rates. Oftentimes, renegotiating with the current lender is a good strategy since you may have already developed a strong business relationship. Sometimes is pays to visit with other lenders to know what is currently going on in the "credit market" (i.e. interest rates, terms of the loan, etc). For example, some lenders offer fixed rates while others offer loans with either variable or fixed interest rates.

Agriculture is a capital-intensive business, and most farmers and ranchers have some debt. Reviewing the cost and returns of using debt capital in a farm business can impact the profitability of the business. Capital, both equity and borrowed, is a valuable resource that needs to be managed to maximize its effectiveness.