Opportunities and Risks
One of the most useful tools in the finance world is the line of credit (LOC). This is a commitment to loan up to a specified amount of money to an individual or entity.
The debt can be borrowed, then paid down, then borrowed again – many times at the borrower’s discretion. Additionally, an LOC is generally secured by short-term assets like accounts receivable and inventories. However, it can also use other forms of collateral like equipment and real estate.
Generally speaking, the LOC is used to finance operating expenses – making it a very helpful instrument in the “cash cycle” of a farm operation. For the crop producer, the cash cycle starts when funds are used to pay for the next round of crop inputs like seed, fertilizer, chemicals, etc. For corn and soybeans, this could start with prepaid expenses right before the calendar year-end.
The cycle then extends through the planting season as additional inputs are purchased. It moves on into the growing season, when additional fertilizer applications and weed control measures occur. Then comes the harvest – when the inputs are officially converted into inventory.
Depending on the borrower’s marketing plan, that crop may get sold at harvest – or it could be held for an extended period after harvest to take advantage of higher prices. Even if the crop is sold at harvest, some producers may defer their income until after the first of the year. The important thing to note is that the cash cycle ends when the last of the crop has been sold and the payment has been received.
So, from beginning to end, a crop producer’s cash cycle can last six to 18 months or more. The longer the cycle, the greater the demand for cash along the way. And, funding gaps can certainly arise depending on how much cash or marketable assets a given producer has during this cycle.
Here is where the LOC becomes a very useful tool for today’s ag producer. In one scenario, inventories from the previous crop year may already be sold for a later delivery date. However, cash is needed now to buy fertilizer. An advance from the LOC can be used to pay for the fertilizer and allow the producer to follow through with the marketing plan. Once the previous crop is sold and payment is received, the producer can take those proceeds and pay down the LOC.
There are many scenarios like this that demonstrate how the LOC can be an effective apparatus for funding short-term gaps in cash. However, there are many other scenarios that point out the risks associated with the LOC.
The LOC can make it difficult to tell if the producer is operating at a loss. As noted above, the cash cycle for a corn and/or soybean crop can be pretty long. When a producer overlaps that with the cash cycle for a wheat crop, which starts during a different time of the year, it’s virtually impossible to use the checkbook to determine whether they’re profitable or not. Operating losses could be happening, which won’t be discovered until after they’ve occurred. The evidence will be a higher residual balance in the LOC. This makes it imperative that the producer knows their true operating costs and the prices at which they need to sell in order to lock in profits.
Also, the LOC can be used for making equipment or real estate purchases, rather than operating expenses.
One might say, “I paid cash for that planter (or tractor, or farm, etc.).” And, there may have been cash in the checking account at the time of the purchase. But, if there was an outstanding balance on the LOC at the same time, should that cash be used to purchase a longer-term asset rather than pay back the LOC? We’ve already noted that it’s hard to tell if one is netting a profit by just looking at the checkbook.
Unfortunately, many producers can easily justify “cash” purchases, only to find their LOC has a higher balance at the end of the cash cycle. Most of the time, that wasn’t excess “cash” as a result of operating profits. That cash should have been paid down on the LOC.
If the producer really needed the equipment or farm that was purchased, then longer-term financing should have been utilized instead.
In summary, the LOC is a powerful and useful tool to help today’s ag producer fill in the funding gaps of long cash cycles. While there are many opportunities associated with this instrument, many risks are found as well.
If each producer will work to manage this tool properly, they will reduce their chances of falling into pitfalls like those mentioned above. And, they will be positioned to benefit from the opportunities as well.
Joel Maneval is the Agricultural/Commercial Lender at Arvest Bank in Joplin, Mo. He and his wife, Tami, have a small farm with their two sons near Jasper, Mo., where they have beef cows and Boer goats.http://www.ozarksfn.com/2018/09/24/opportunities-and-risks-2/Ag-VisorsJoel Maneval,line of credit,Maneval,opportunities,risksOne of the most useful tools in the finance world is the line of credit (LOC). This is a commitment to loan up to a specified amount of money to an individual or entity. The debt can be borrowed, then paid down, then borrowed again – many times at the...Joel Maneval email@example.comAuthorOzarks Farm & Neighbor Newspaper