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SW Financial Literacy
How To Get Financed Part 2: Capacity
Getting approved for financing isn’t random, the 5 C’s of Credit are fairly well know and used universally:
Character
Capacity
Capital
Collateral
Conditions
Each lending institution looks at these a little different and may prioritize one over another. To get approved for financing, you need to chin the bar on most of the C’s. To get the best terms out of your financing, you want to accel at all 5. The more you know about them, the better you can be prepared.
To read previous articles in this series:
Make sure you check out the Bonus Ratios at the bottom!
Projection
Will your farm make money this year?
Put together a farm income/expense projection at the start of every year. Use your best conservative estimates for commodity prices and input expenses. It doesn’t do you any good to inflate the commodity sales prices, your lender will move them to more realistic figures and it doesn’t help you with decision making in marketing or inputs.
Create this baseline projection, then if you are looking to buy ground or make equipment upgrades that will require adding debt, add them to your projection!
Any new income derived from the purchase needs to be included along with the expenses to generate that income. Don’t forget new debt payments need to be factored in. For help creating your purchase scenarios, use this: Balance Sheet + Scenarios – Farm640 (Password is ‘farm’).
Once your projection is complete, is there a positive margin showing earnings? If not, you need to go back to the drawing board and figure out how to generate more income, reduce expenses for your operation, or even bypass the purchase.
Tax Returns
Send your tax returns in. All of it.
All forms, schedules, and attachments should be provided to your lender. Complete information helps your cause as any income that cannot be verified with a form may not be included. This includes income and expenses from any entity which you have majority or minority ownership in.
Grey areas or questions about what you are doing creates doubt, and you want lenders to have confidence in you.
The projection you created above should reconcile with your filed taxes. If your 3-year average repair bill is $75k and you put $10k on your projection, this is a pretty obvious red flag. That is, until you explain that you traded off that lemon of a combine for a new one!
Pro Tip: Depreciation from your tax returns is typically not factored into a loan decision. Accelerated depreciation has been a great tax tool for farmers to keep their tax bill down, but it doesn’t realistically have much to do with you earning a profit and being able to earn money to make your loan payments.
Ratios
You sent in 350 pages of information, what’s next?
This information is used to pull a few key ratios on your operation. #1-2 are needed to calculate #4, which is what you need to know.
1. Net Income After Taxes (NIAT) – Depreciation – Term Interest Debt Payments = Repayment Capacity
Repayment Capacity tells how much money your operation has left over, after all expenses have been paid, to make debt payments.
2. Term Interest + Term Principal = Term Demands
Term Demands are all the annual debt payments (interest and principal) you make that year.
3. Repayment Capacity – Term Demands = Margin After Debt Servicing
Margin After Debt Servicing is your true earnings. After all expenses and debt payments have been made, this is how much money you made.
And all of that brings us to #4.
4. Repayment Capacity / Term Demands = Debt Coverage Ratio
Debt Coverage Ratio is what lenders look at. You typically want your ratio to be greater than 1.25:1. This means that for every $1 of debt payments you must make, you want to have at least $1.25 of profitable margin available to make those payments. The higher your DCR, the more earnings you have to make your debt payments!
Bonus Ratios:
1. Total Farm Expenses (not including depreciation or term demands) / Gross Farm Income = Operating Expense Ratio
A typical Operating Expense Ratio is between 70-80% for a row crop operation in the Midwest. Ask your lender if you are high or low compared to your peers. A lower % signifies you are more efficient at generating income.
2. Term Demands (from above) / Gross Farm Income = Term Demands Ratio
You ideally want this figure below 20% as it represents how much of your income goes toward making debt payments. If your Term Demands Ratio is at 22% and your Operating Expense Ratio is at 83%, you are using 105% of your income to pay for expenses.
Measure these two bonus ratios annually to see if debt or runaway operating expenses get out of line and are the result of decreased profitability.
Show strong ratios and you will check the box on ‘Capacity’. Step #2 for getting financing.
Key Takeaways:
Projection -Accurate yield, price, and expense estimates.
Scenarios -See how a purchase impacts your projection outlook.
Tax Returns -Send everything you have.
Debt Coverage Ratio -You must show profit to make debt payments.
Bonus Ratios -Know where your expenses are out of line.
Have a great week!
Grant
All views expressed on this site are my own and do not represent the opinions of any entity whatsoever with which I have been, am now, or will be affiliated. Information provided is authentic to the best of my knowledge, and as such, is prone to errors and the absence of key details. The content of this blog is for entertainment and informative purposes and should not be seen as professional advice to finances or any other field.