Understanding The Credit Risk Chain

Young plants with a rising trajectory line
19 Oct 2021

Farming is a unique business that is exposed to a variety of risks.  We often think of primary risks such as weather and market fluctuations, but there are many other types of risks that can be related to management and business decisions that prove to be costly.  

With all the risks involved in the complicated business of farming it is important to understand that any of these risks can lead to a potential loss of income. For this reason, it is important to understand how your business can absorb and manage through the risks that could lead to a potential loss and/or total business failure.  

As your lender, AgCountry likes to view ourselves as your tool for financial analysis. We want to help you understand how your farm operation is prepared to absorb loss. One tool AgCountry uses to evaluate credit worthiness is a seven-step process we call the “credit risk chain” or “business management risk chain.”  Here is an overview of the seven steps of the risk chain:

Step 1. Marketing and Risk Management Tools:
We consider whether the borrower carries adequate levels of insurance such as multi-peril crop insurance (MPCI), hail, property and casualty, and even life insurance. We also consider what their marketing plan is.  Do they have a well thought out marketing plan? Production and/or price risk can be mitigated through forward contracts, hedging options, hail insurance and/or MPCI.  We typically look at what the gross income of the crop and/or livestock of the operation is and shock that income by 20%, which carries to the next link in the risk chain. 

Step 2. Earnings:
Initial risk factors in the risk absorption is the profit margin of the operation. This is the income for the operation after taxes, non-farm income, and family living withdrawals. The 20% “shock” risk not covered by insurance can reduce net earnings. If that risk is greater than the profit margin, it would carry over to the next step in the chain. A business can still make a profit and not cash flow, so we need to consider both income and cash flow risks. 

Step 3. Working Capital
When it comes to the measure of business liquidity and potential cash position, the old saying of “cash is king” is quite accurate. Working capital is the difference between current assets and current liabilities. Working capital divided by your Adjusted Gross Farm Income gives your liquidity percentage. A minimum liquidity standard AgCountry requires is 15% of your annual Adjusted Gross Farm Income. This 15% is a base amount of working capital the business should have. Any working capital over that base amount is vital to absorb risk of loss or risk of inadequate cash flow. Working capital below 15% creates a deficiency that is moved to the next step. 

Step 4. Capital Debt Repayment Capacity (CDRC):
This is your operation’s projected amount of cash flow available to repay annual demands. Repayment demands are what is due annually for principal and interest on capital loans, capital leases, Capital Asset Replacement (CAR), and working capital deficiency.  You can calculate CAR by determining a normal depreciation for machinery, vehicles, and buildings minus the annual principal repayment of debt associated with those assets. Any positive difference is included in demands. When it comes to CDRC, we calculate by adding your net earnings (after tax and family living withdrawals) plus depreciation and interest on capital debt. This is than divided by total debt services demands. We measure CDRC by a percentage of total demands. We consider a CDRC percentage of 115% or higher as a minimum for financial standards. If CDRC is at 115% or greater, it means that your operation has the ability to meet all demands along with the ability to have excess funds go towards any shortages or rebuilding working capital. If CDRC is at 100%, every dollar of earnings is committed to debt service and demands, which means there is no room for additional risk or loss; it is essentially a break-even. If it falls below 100%, then you start to see a deterioration of equity on the balance sheet, primarily in the working capital position. This level of the risk chain is a measure of repayment ability the operation has towards financing additional debt compared to the present debt structure. If the operation has the ability to finance additional debt based on repayment capacity being met, this is then carried to the next step of the risk chain. 

Step 5. Owner Equity:
This is the share of total assets of a business. Your net worth is calculated by your total assets minus total liabilities. Net worth is the dollar value of your equity in the farm business. Owner equity is measured by taking total net worth divided by total assets. We consider 50% or higher owner equity as the minimum financial standard. The higher your equity percentage the greater ownership and greater your financial stability and risk bearing ability is. If your operation is at this step in the risk chain, you have to make tough decisions. One option is to restructure assets and debt down the balance sheet in order to move your risk bearing ability back up. This is dependent on availability of assets to use to leverage when restructuring. If owner equity is below 50%, then there is not a lot of room for additional debt restructuring. The last option would be to sell assets to pay down debt. We need to keep in mind, however, that asset sales come with tax and cash flow implications.  The selling of assets - often collateral - moves us to the next step in the risk chain. 

Step 6. Collateral:
Collateral is a contractual agreement between the borrower and the creditor. The borrower agreed to pledge assets to the creditor that can be re-sold if a loan is not repaid. This step essentially creates the leverage to ensure steps one through five on the risk chain happen. This is often the last resort.  

Step 7. Other Risk Mitigation Factors
At AgCountry, we will look for any other way to strengthen the credit risks, which vary for each farm operation. Some of the ways we can look to offset risk when the risk chain progresses are to look towards parental support (if available), co-markers, and personal guarantees or Farm Service Agency government loan guarantees. In most cases we look towards these to strengthen Step 5 in the risk chain.

The risk chain is a tool for the creditor to help themselves and their borrower understand where their farm business is at in the risk chain. This system allows both parties to know in advance, if the risks materialize, what will be expected and what borrowing power they will have. The borrower needs to be comfortable with the levels of uncertainty or have a plan that reduces uncertainty to match their risk tolerance. A borrower should also be confident their lender knows their risks and has better certainty of their objectives and lending arrangements. It is a good idea to review these objectives periodically throughout the year.  

VP Branch Manager - Lisbon
Written By: Parker Wiltse
VP Branch Manager - Lisbon