Surviving financial distress
October 4, 2017
If you are one of the many farmers or ranchers that have taken a loss the last couple years due to the markets and drought, then this information is for you.
Having recently taken up financial consulting work again, I am seeing more dollar losses taken on operations over the past couple years than what I believe was lost in the 80's. Fortunately, most operations have built up significant equity by retiring much land debt over the past 10 years as well as realizing substantial appreciation in value. Newer operations carrying any significant debt load, however, are facing some real difficulties ahead. The object is to survive this financial distress until this slump is over. The information I am going to share with you may help you save your operation through these difficult times.
The first thing you need to know is that your banker has no loyalty to you. Banks nowadays are held by large holding companies, and some are publicly traded. Very few are owned, let alone managed by individuals or a local board. The laws governing banking today do not allow for special treatment of the "good ole boys." If you as a borrower find your ratios are upside down, you will learn quickly having banked there for the past 20 years mean nothing. So if you think for a minute the bank is going to carry you next year with carry over losses this year, you may want to listen up.
Secondly, UNTIL YOU KNOW WHERE YOU STAND FINANCIALLY, DO NOT SURRENDER THIS YEAR'S PRODUCTION INCOME TO YOUR LENDER. This is imperative if you have any sense you are sinking in a financial quagmire. Banks are notorious for telling you to bring in all your income and pay down the debt and they will "take a look" at things then for next year. This may be a set up. Many this year will take in their income and try to renew their operating loan only to find out they are denied…..and furthermore, the bank has all your assets tied up as collateral, so there isn't, much hope of getting the bank down the street to provide operating…basically, you are done. But if you can foresee this event, there are methods as to how you can use your production income from this year as operating funds for next year, and perhaps for future years, and salvage your operation.
I am going to explain in the following paragraphs a short method for you to determine your own financial stability from a banking standpoint. If you find you do not qualify as a bankable credit after this short test, then I will give you further instruction at the end of this commentary, as to what you should be considering to be your next move.
Your balance sheet and cash flow budget are key in analyzing your own situation. Many of you do not pay much attention to these documents, and only know that the bank requests you to update one every year. What I find most disturbing is that very few bankers even discuss these documents with their customers, which I believe is tragedy. I don't know if this is intentional, or if they just assume their customers understand what they are providing. If you are one of those who really don't know how to read your own financial documents, then here is a crash course:
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Take a look at your liquidity ratio. This is your current assets divided by your current liabilities….normal crop and livestock production that will be sold this fall to pay all that is due by year end. Banks want to see a 1.5:1.0 ratio, and at the very least 1:1. If you have less than a 1:1 ratio, your trouble is already here. That means you are most likely going to carry over a loss into the year and your banker will have to decide what he is going to do with the carry over debt going into next year. If you have a lot of equity in your property, the correct answer would be to term out the carry over debt, securing it with hard assets, such as machinery/equipment or real estate. The term should be determined by the life of the collateral. 5-7 years for M/E and 20 years or more for land. I find many lenders are reluctant to do that for some reason, and would rather roll it into next year's operating loan, making all of it due in the fall again. If your cash flow can handle this, then this may be justified. Otherwise, this is just a band aid to get you further in trouble and reason to call the loan at year end.
For you to determine if you have equity to term out carry over operating debt, you will need to calculate your debt to asset ratio. Your debt to asset ratio is determined by taking all your debts and dividing them with all your asset values. Banks want to see less than a .30 ratio. Anything above 30% but less than 50% is acceptable, as long as the cash flow can service the debt, but anything over 50% is considered to be a red flag in banking. Since 2015, machinery/equipment and cattle have dropped in value, pushing many of these ratios over 50 percent, with no regard to past performance.
Next, is your cash flow. Most of you understand this document, and many of you fight it. Budgeting for next year in this environment is a crapshoot at best. As one commercial lender said to me in my ag lending days…"you guys are like wizards…..loaning money on projected income coming from nothing!" Agriculture is risky business, and all we can do is work with the information we have at the time using historical data as our guide. Banks want to see a cash flow margin of 115% or more. This is measured by taking all income to be received and dividing it by all your expenditures, including expenses to operate, interest expense, living expenses, capital replacements, and debt payments. If you are below 115%, but above 100%, it is acceptable, but may end you up on the watch list.
This completes your short test: liquidity ratio, debt to asset ratio and cash flow margin. Any of these ratios outside what the bank is wanting, has to be mitigated, with the exception of cash flow. The credit must show a positive cash flow margin, or it is doomed for sure.
Banker's all got the memo this past year that agriculture was not going to be good for a couple more years, and interest rates were most likely going up. Upper management was warned that if they had any banks in areas with high concentration of agricultural loans in their portfolio, they were to scrutinize those loans highly, and get rid of any loans that were "substandard in their safety and soundness exam." If you are getting some vibes from your banker that makes you uncomfortable, then you are probably on that list.
So what do you do if your ratios are not acceptable, and you sense you may be on that list?
The first thing I suggest is to get an opinion from a third party that understands financial documents and banking. I will put my plug in here and say that is what I do for a living. I would complete an analysis of your financial condition and provide you feed back as to how you size up with your bank and your peers. I would also provide you with various options as to how to deal with any areas I see as problematic. And then I would offer further services to assist you in negotiating with the lender on your behalf if needed.
Many times problems in credits are created by improper banking terms. Yes, it's true, bankers cause problems. One example I dealt with recently was a loan made for an irrigation pivot. The banker set it up with a one year payback period, and took a real estate mortgage. When the operator could not pay back the operating loan and the irrigation loan at the end of the year, the banker began foreclosure proceedings. Remember I said that loan terms are determined by the life of the security? Banking 101. In this case, we ended up in a chapter 12 bankruptcy action, and reorganized our client's debt with a proper 20 year amortization…..where it should have been to begin with.
The "B" word, has haunted many folks as being a sign of failure or mismanagement. But in fact, with today's banking regulations and bank mentality, banks are many times unable to restructure loans and automatically put them back on the books as a "standard" rated loan. Therefore, banks oftentimes welcome a bankruptcy petition so as to take it out from under the scrutinizing eye of the examiner. This enables the bank to work with the borrower under different venue and can be a good thing for both parties. But even if the relationship is strained, it provides a legal barrier for any collection efforts and allows the borrower time to work on a plan of reorganization that works best for him. So this raises the question as to how to you operate your business as a going concern while going through bankruptcy if you do not have access to operating funds? Remember what I said earlier about not remitting your production income to the bank until you know what your financial condition is? That is what you would use while going through bankruptcy. If you take in all your production income, then file bankruptcy….it is more than difficult to operate with no available funds…..and no, FSA will not loan you operating while in bankruptcy.
So is bankruptcy your only option? No. Many of the banks in your area have come to learn that putting everyone in bankruptcy is not always in their favor, either, so they have become more negotiable than a year ago. Some have hired "special assets" officers that do nothing but work on classified credits. They have been given authority to work with some latitude, so as to come to some semblance of an "in house" bankruptcy reorganization or liquidation plan, rather than go through foreclosure. The time a borrower has the most leverage in working with these guys is right now, before you take all your harvest to them…..not after the first of the year. And I find having a third party advocate work with you on these negotiations is beneficial. If you go in with your attorney, they will be there with theirs….and many times that becomes counter-productive.
In closing, I want to again emphasize — take time to analyze your financial condition now, before you take in your harvest. If it appears you may be heading for trouble, now is the time to act, before you give up your position. And don't sign any new documents until you have read them or have someone else look at them. Shrewd bankers such as our Farm Credit friends are notorious for sliding new lien documents in front of you to sign, especially if they are not sure they are perfected in all their lien filings…..just before they begin collection.
Proverbs 22:7 (NIV), "The rich rule over the poor, and the borrower is slave to the lender." F