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Manage seasonal cash shortages with farm operating loan

By Paul Dietmann and Ron Bula, Badgerland Financial

Most farm operations encounter months in which the money coming in from sales of milk, livestock, produce or other products is not quite enough to cover all of the bills. Hopefully, the farm’s checking account balance is enough to carry it through until cash flow turns positive again. But what if the checking account runs dry? What will the farm family do to get by?

Often, the first move when cash runs short is to slash family living costs such as health insurance. Next, decisions are made about which bills absolutely must be paid and which can be pushed off for a month or two. Some farms may opt to use vendor financing programs at 7-10% interest rates, or pay bills with credit cards that accrue interest at 18% or more. We once worked with a farm family that dealt with negative cash flow by taking a loan with a household finance company at an interest rate in excess of 30%! Any of these strategies can potentially damage a farmer’s credit rating and make it more difficult to operate in the future.

There is a better way to deal with periodic cash flow shortages but it requires some planning ahead. If you wait until you run short of cash, it’s likely too late. The best way to prepare for seasonal cash shortages is to establish an operating loan for the farm.

An operating loan is essentially a short-term reserve fund held by a lender that is available for the farm to use when cash flow is tight. Interest rates are typically less than vendor financing or credit cards. Interest charges only accrue when funds from the line-of-credit are being used, and stop accruing when the funds are paid back. If the operating loan is never used, it generally won’t cost you anything to have it available just in case you might need it. Once the operating loan has been established, funds can be accessed quickly with an electronic transfer to the farm’s checking account or other means.

To establish an operating loan, you first must decide the maximum amount of operating credit the farm might need to have available. The best way to make this decision is with a month-by-month cash flow projection that covers at least one full year. Look for the biggest monthly deficit you might encounter during the year. Your line-of-credit should cover that amount, plus a bit more.

The month-by-month projection should start with the amount of cash on-hand on the first of the month. To that amount, add all expected income each month (including non-farm income) and subtract all cash expenses being paid out each month. The monthly cash outflow should include all operating expenses, scheduled principal and interest payments on loans, and family living expenses. The bottom line will be a prediction of that month’s ending cash balance and the beginning cash balance for the following month.

Tip: Badgerland Financial offers a fillable spreadsheet to help you project your month-by-month cash flow. Go to badgerlandfinancial.com/en/Pages/Resources.aspx and select “Simple Cash Flow Projection Worksheet” under the fourth bullet.

Going through a month-by-month cash flow projection is a very valuable planning exercise for any farm of any size. After reviewing the projection, you might decide to make changes in your farm enterprises that will smooth out the farm’s cash flow. Maybe you’ll decide to build up the farm’s working capital reserves during good months to reduce the need for a line-of-credit. Perhaps you’ll choose to work off-farm at certain times of the year to supplement farm cash flow.

Applying for an operating loan is similar to applying for any other type of farm loan. Your lender will need a recent, detailed balance sheet that lists all of your farm’s assets and liabilities. He or she will also need several years of tax returns and will want a copy of your month-by-month cash flow projection. The underwriting process will include a check of your credit bureau report.

The first time you take an operating loan, the lender will likely ask for collateral to secure the loan in the event that you are not able to pay it back. The collateral might be a security interest in crops or livestock, machinery, or other assets. Because an operating loan is only intended to be used for short-term cash flow needs, it typically needs to be completely paid off within one year.

One unique feature of an operating loan is that there usually is not a required monthly payment. The farm makes payments on the operating loan as cash becomes available. Loan payments are first applied to cover accrued interest and then to pay down the principal balance. The flexibility of not having a set monthly payment is nice but it is important to have the discipline to pay down the operating loan as soon as you are able. You don’t want to reach the end of the year and suddenly have to pay back the entire operating loan in one lump sum.

After your first year of successful experience with your farm operating loan, you may be able to renew it for a term longer than one year.

The benefits of having an operating loan available for your farm’s use are obvious. However, an operating loan also carries its own risks. The biggest risk is the possibility of not being able to pay it off within a year. This sometimes happens when the operating loan is used to purchase farm equipment or other capital assets. That can be rectified by shifting the equipment off of the operating loan to a longer term loan. A more serious situation is when the operating loan is used for its intended purpose—short term cash expenses—but there isn’t enough cash flow during the year to pay off the loan.

A rise in interest rates is another potential risk with operating loans. Often, an operating loan will have a variable interest rate, which means the rate can possibly change each month. Some lenders offer operating loans that are tied to an index such as the prime lending rate or the London Interbank Offer Rate (Libor), which can reduce the risk associated with a potential interest rate increase.

There are many tools that farmers can use to accomplish tasks on the farm. Consider an operating loan to be a helpful financial tool to include in your toolbox.

Paul Dietmann is the Emerging Markets Specialist and Ron Bula is an agriculture lender at Badgerland Financial, a member-owned Farm Credit System institution in southern Wisconsin.

From the May | June 2015 Issue

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