Agricultural Lending

Financial Analysis

The quality of financial information for agricultural operations varies significantly. In general, traditional small-farm operations use cash-basis tax returns and market-value financial statements that are self-prepared and unaudited. Larger operations and vertically integrated companies frequently will submit audited, accrual-basis financial statements.

When reviewing a farm operation’s cash flow, it is important to understand that farmers have the option of reporting income for tax purposes on either a cash or an accrual basis. As a result, reported cash flow levels may require further analysis. By using cash accounting, the timing of crop sales and purchase of supplies can be used to minimize taxes. For instance, fertilizer can be bought at year-end, expensed to the preceding crop, and used in the next tax year. The purpose of this treatment is to minimize the effects of losses in bad years by allowing expenses to be allocated to good years.

Because of the broad spectrum of agricultural activities (livestock, fruit, grain, dairy, storage elevators, vineyards, nurseries, and others), the types of financial analyses involved in farm lending also vary. Each operation presents issues that are unique, and it is important that the bank lender fully understand the critical factors and nuances associated with each operation being financed. Despite their differences, however, some key elements of financial analysis apply to all situations. These are:

Financial projections, whether prepared solely by the borrower or jointly with the banker, should be realistic when compared with historical or regional standards. All assumptions should be clearly documented and subjected to sensitivity analysis.

Some agricultural borrowers, particularly smaller operators, submit only one financial statement annually. In these instances, the best way of determining an operator’s effectiveness is by comparing projections with actual historical performance. This involves reviewing and comparing results for several fiscal periods. It would not be unusual for a loss year(s) to be experienced during this period; however, the analysis should focus on determining whether profitable years more than offset loss years.

Trend analyses can also provide a reliable basis for credit decisions. As an example, increases in reported property values and net worth resulting primarily from simply increasing the carrying value of already-owned property should be closely analyzed to confirm that the new values are consistent with local market conditions. By performing this type of analysis, and making any necessary adjustments, the lender can help ensure that loan amounts do not exceed the borrower’s realistic collateral values and ability to repay.

Some operations require large, ongoing capital expenditures to replace equipment or machinery, maintain industry standards, and remain competitive within their market. The lender should determine the financial impact of such “maintenance” capital expenditures as well as the appropriateness of capital expenses for expansion or modernization. In some cases, the farmer may be motivated to improve the operation’s cash flow by delaying or forgoing maintenance or investment capital expenditures. The bank and the farmer must understand the risk involved in these practices and evaluate their potential impact on ongoing operations and loan performance.

Many agricultural borrowers have sources of income other than from their crops or livestock, such as cash rents, royalty payments, custom work, government payments, and non-farm salary. It is important to evaluate the level, duration, frequency, and availability of this income. Any loan repayments dependent on these sources should coincide with their receipt.

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