Increasing Your Odds for a Refinance Request - by Dr. David Kohl
By Dr. David Kohl
The economic downturn in the agriculture industry is in full steam in many regions of the country. Rapidly dropping commodity prices, stubborn inflated costs, and the doubling of interest rates are combining to magnify losses resulting in a drawdown of working capital reserves on the balance sheet. Many producers who have been at my seminars have indicated that operating lines of credit will not be paid down and refinancing of losses will be on the horizon. In this article, we will discuss the game plan that needs to be prepared and executed to increase a producer’s odds for a positive response from the lender. I will draw on my experiences working with borrowers and lenders in the past and two positive workouts at our dairy creamery.
Respond and be proactive
First, do not wait until the last minute to make your request. Expect much more financial documentation and analysis of your situation by your relationship person, the credit analyst, and loan reviewers.
Next, be proactive in checking your credit scores and credit reports. These reports will be requested from any individuals cosigning on the loan documents and the financial statements. Be aware that up to 20 percent of all credit reports have inaccuracies that can lower the scores. Being ahead of the game and correcting these blemishes will be a step forward in improving a positive response.
Accurate and up-to-date balance sheets with schedules and supporting documents to validate assets and liabilities will be essential. Lenders do not like surprises! Accounts payable left off of the balance sheet or machinery leases not reported only raise doubts in the credit analyst’s mind about the accuracy of the financial statements. Be reasonable when valuing assets. Keep in mind that machinery values are one of the first to decline in a down economic cycle in agriculture, followed by grain and livestock inventory without a marketing and risk management plan that can result in fluctuating values.
Transparency, honesty, and a frank assessment of why the shortfalls occurred need to be discussed and documented in writing. For some it may have been an issue with executing a marketing plan for grain in storage, which has resulted in losses. For other producers it could have been weather issues or the use of the previous year’s profits to purchase long-term assets which, in turn, drained working capital reserves. The key is do not beat yourself up; everyone makes mistakes. Put your energy into a plan for correction and improvement.
Projected cash flow budgets
Do not expect your lender to fill out your financial statements including a projected cash flow. Also, an annual cash flow statement will not be sufficient in a refinance situation even if you are operating an enterprise where the bulk of your revenue is received once per year.
A quarterly or monthly cash flow is essential. Make sure you list out your assumptions on production, prices, costs, and the new debt service for the refinance terms. Keep in mind that a refinance will increase your cost of production both in the short and long run, which will impact the breakeven point.
In your analysis, it is important to do a best, average, and worst-case scenario with key variables and assumptions in the cash flow. What is your plan for improvement? The following are some plans that have been observed over the years.
- Eliminate unprofitable aspects of the business including marginal farm ground or unproductive assets. If you do sell unproductive assets, what are the deferred taxes? The gains on asset sales will be the difference between the sale price and the basis, which is the cost minus the remaining depreciation.
- What were the mistakes that were made before and what is the plan in place so the mistakes are not repeated?
- What costs are you going to cut without hurting your effectiveness of the bottom line in both the short and long run?
- What is your cost-cutting and revenue enhancement plan to get back to breakeven or a positive debt service coverage ratio?
- Test the various situations using spreadsheets with the assumptions.
- Develop a family living budget that is separate from the farm budget. Isolate non-recurring expenses such as tuition if a child is graduating from school. Remember, individuals often cut family living costs in the short run but revert back to former spending habits within two or three years.
Monitoring
The key after the plan for improvement has been developed is to consistently monitor projected versus actual results. I have found that periodically meeting one-on-one in person or virtually with the lender can be very useful in determining the progress and what needs to be tweaked along the way. Interaction and engagement enhance trust, build relationships, and are a win-win for both the borrower and lender.
If losses continue, a candid assessment of the business and the long-term replenishment of working capital reserves will be important. This assessment often results in the use of a working capital burn rate, which is calculated by dividing losses into working capital. Knowing the strengths and weaknesses of the working capital reserves can be useful in long-term success.
In conclusion, the tough part of the economic cycle is often when the best management practices are put into action. This in turn leads to better business decision making so one can hit the ground running when the positive part of the economic cycle occurs.