For some farmers, as Yogi Berra put it, “it feels like déjà vu all over again.”
It wasn’t that many years ago when farms were often required to manage with little or no working capital.
I’m talking about liquidity issues, more commonly expressed as cash flow problems.
There can be several reasons why this happens and some are beyond a farmer’s control.
However, whatever the reason, ending up in a “tight cash” position can be challenging. Farmers may be wondering what they can or should do.
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A good first step is to visit the bank sooner rather than later. Maintaining regular communication with lenders when facing a potential financial crisis is critical.
Several options are available for farmers with inadequate cash flow.
They may want to consider selling assets or contributing personal money to the business.
They might even pursue equity capital, which is asking someone other than a lender to invest money in the farm.
Restructuring, commonly known as terming out debt, is another consideration. It involves re-organizing a business’s debt.
Debt is categorized as both current debt, which is due to be repaid in the next 12 months, and long-term debt.
This column will focus on the restructuring option.
In its simplest form, restructuring debt in a business moves some or all of the current debt to long term. There will be a corresponding repayment schedule.
It doesn’t increase the overall debt in a business, but it does increase the owner’s commitment to making principal and interest payments.
The benefit is that some or all unsold inventory can now go to operations, as opposed to dealing with current debt obligations that exist before restructuring.
If the original operating loan limit was left intact, those funds are also available to finance operations.
However, restructuring may bring other issues.
The farm has to have the proven ability to be able to make the additional principal and interest payment. The restructuring may not be possible if the repayment history is weak. This could also result in having to look for a new lender.
Lenders that perceive more risk will usually demand additional security in the form of equity in assets. Unencumbered assets (land) are the best source of additional security.
However, farmers should give careful consideration before mortgaging clear title land.
A lot of cash flow pressure usually exists before restructuring, and the pressure to get some shorter-term cash flow relief can be enormous. Take time to think carefully about the longer-term commitment and related risk.
Arranging any amount of re-structuring will be an accomplishment for farmers in more severe financial situations, but the issue for those with lots of equity is how much of their current debt to term out.
It may sound strange, but sometimes there is a risk in not terming out enough current debt.
Farmers need to determine how much working capital is needed to finance operations until the 2016 crop inventory will be ready for sale. Examining past cash flow will provide a good indication as to what they will require.
Farmers will want to arrange the restructuring accordingly so that they term out enough of the current debt to end up with the desired working capital.
They also want to test against their farm’s earned ability to make the additional principal and interest payment.
They should first determine their average net earnings before depreciation and term interest expenses are included for the past three to five years. Divide this number by the annual principal and interest commitments before the restructuring. This is the debt servicing ratio.
Now, take the same net earnings but divide it by the annual principal and interest commitment, including the new restructuring commitments. This is the revised debt servicing ratio.
When comparing the two, try to keep the new ratio at 1.5 to 1, or in other words $1.50 for every $1 of principal and interest.
Allowing the debt servicing ratio to fall to 1.25 to 1 or lower as a result of restructuring can be problematic over the life of a loan. Risk increases as the debt servicing ratio approaches 1.25, especially as the length of the loan (amortization period) increases.
A 20 year loan with a debt servicing ratio of 1.25 to 1 is considerably more risky than a three year loan with the same ratio.
When restructuring debt, it’s important to consider each option carefully and seek professional advice from a lender and independent farm management adviser.
