There are several factors that go into a lender’s decision whether or not to renew a line of credit. It is just like school. You take the exam, and the grade determines your financial health.
Do you have a balance sheet?
The first question is pass/fail. If you do not answer it correctly, you do not get to continue. If the answer is yes, you still may not have all the points. Ideally, you would have several years of financial statements so the lender could see the trend in your financial health.
Do you have enough cash or liquid assets to pay off your short-term debt? Do you have more assets than liabilities?
The answers to questions two and three are on the balance sheet. The balance sheet is a list, as of a certain date, typically the end of the year, of all the assets (what do you own) and liabilities (what do you owe). The difference between assets and liabilities is the owner’s equity in the farm. Assets are divided into two categories, current (used up or sold within one year and cash on hand) and noncurrent (machinery, breeding livestock and buildings). Liabilities are also separated into the same two categories, current (due and payable within one year) and noncurrent. Lenders calculate ratios and compare them to standards to analyze financial health.
The answer to question two is the Current Ratio or current assets divided by current liabilities. If the ratio is greater than 1.0, then you have more current assets than current liabilities. Notice on the Scorecard that a ratio less than 1.3 is considered vulnerable and greater than 2.0 is considered strong.
The answer to question three is one of the “solvency” ratios. The farm debt-to-asset ratio tells the lender whether you have more assets than liabilities, e.g. do you have enough collateral to take on additional debt. Again, looking at the Scorecard, if your debt is equal to 60% or more of your assets you are vulnerable, but if your debt is only 30% or less than your assets your financial health is considered strong.
Do you have an income statement?
Question four is like question one. The income statement is a summary of revenue and expenses for a given period, normally a year. Again, it takes more than one year of information to establish a trend.
The income statement includes revenue and expenses from normal farming operations and from the sale of capital assets. Although most farmers are on the cash method of accounting, financial analysis requires accrual-adjusted numbers, e.g. what generated revenue this year even if you postpone the actual payment to another year.
Hopefully, the farming operation generated a profit (revenue greater than expenses). The amount of profit alone does not tell the entire story. Two operations may generate the same amount of profit, but one required twice the amount of assets (labor and equipment) to produce the profit. So, again, ratios are calculated to analyze financial health.
Rate of return on farm assets is used to calculate the profitability of the operation. The Scorecard considers a rate of return less than four percent as vulnerable and greater than eight percent, strong. Repayment capacity and financial efficiency ratios are also calculated from the data on the financial statements.
This has been a simple explanation. There are many other issues, e.g. should the balance sheet have assets listed at cost or market value and several more ratios that are usually calculated. Lenders also consider non-financial information, such as history with the lender and reputation in the community. The more financial information you have, the more the lender will be able to learn about your operation; and the lender usually has to know your operation before making a loan.
*This article is for information purposes only and is not a substitute for legal advice or recommendations.