From the ground up

There’s more to building a farm than obtaining acreage, lumber, fencing and equipment. Some of the first steps for new and beginning farmers include gathering information and obtaining a loan.

“First is your state’s land grant Extension service,” said Chris Laughton, director of knowledge exchange, Farm Credit East. “They will have resources for farming of all types as well as Extension services for beginning farmers. Every state has a USDA Beginning Farmer and Rancher Coordinator, which can be found through FSA.”

For business coaching, Laughton recommends the Small Business Administration’s Service Corps of Retired Executives (SCORE), which critiques business plans and provides business insight.

The Farm Credit system was established by the U.S. Congress in 1916 to provide stable and reliable credit to rural America. Today, more than half of U.S. farmers have a Farm Credit relationship. Those in the Farm Credit system are members and are eligible for dividends based on the system’s profitability, which reduces the borrowing cost.

One Farm Credit priority is young, beginning, small and veteran farmers who are eligible for incentives, including discounts on financial services and payment of FSA guarantee fees. Farm Credit is an FSA preferred lender.

Creating a financial statement is one of the first steps prior to approaching a loan provider. Laughton said while financial statements aren’t everything, they matter.

“Farming is a lot more than just a business,” he said. “Lifestyle goals are equally important as financial goals. If you aren’t economically sustainable, quality of life can decline quickly. Financial stability and profitability are prerequisites to other goals.”

Financial records help the farmer think about profitability and allow projection of the farm’s likely financial performance early in the process. Records also help measure progress over time to make better-informed investment decisions, facilitate financing and are essential for farmers applying for grants.

The ideal financial documents include current balance sheets, current income statements for existing operations and cash flow projections by the month for least one year.

A balance sheet lists assets – everything owned or payable to the business on the date the sheet is prepared. It also lists liabilities, which include all obligations owed by the business on the balance sheet date. The owner’s equity or net worth is total assets minus total liabilities.

The balance sheet for a beginning business documents all assets and liabilities at a point in time and allows the lender to calculate important measures of liquidity (the ability of the farm to meet its current liabilities) with current assets and solvency (the ability of the farm to pay off all debts if it would be sold tomorrow). It also shows progress in the farm business even if cash flow is tight. The balance sheet should align with the federal tax return, which makes financial analysis easy.

The income statement includes income, expenses and net income. Gross sales minus the cost of goods sold equals gross margin. Gross margin minus overhead (fixed) costs equals net profit.

“Cost of goods sold are what you put into your product,” said Laughton. “For a corn farmer, the cost of goods sold includes fertilizer and seed. For a vegetable farmer, cost of goods sold includes seeds, starter plants, fertilizer and production labor. The result is gross margin, which is what you have left to pay overhead, and profits. Overhead includes equipment depreciation, property taxes, owner’s salary and insurance.”

While overhead items don’t go directly toward profit, they should be included in the budget because they’re necessary business costs.

Laughton explained that cost of goods sold are product inputs, which typically grow linearly as production is expanded. Overhead costs are often referred to as fixed costs because such costs don’t typically change if production is increased incrementally.

For example, farm insurance doesn’t change if corn yield increases or another row of vegetables is established. These costs change in steps as the farm grows.

“The result is net margin (or net profit, or profit),” said Laughton. “A 10% percent of sales is typical for a lot of farms. It shows how quickly the money goes. A 10% net margin isn’t bad – I’ve seen anything from 5% to 25%, and it’s rare to see more than 25%. It’s important to keep track of this – it’s what pays principal on loans and reinvestment in the business.”

Reasons for a low gross margin include low pricing (which may be an aspect the farmer can’t control), the cost of goods sold is too high or perhaps shrink is too high.

“Shrink is important to track,” said Laughton, adding that shrink is a killer in agriculture. “Shrink is any product from or made that cannot be sold due to lack of demand, poor quality, spoilage or theft.”

Farm lenders typically consider the five Cs of credit: character (how you’ve handled credit in the past); capacity to repay (determined by earnings before and after the investment); collateral (the lender’s fallback position which can include real estate, ideally, livestock and machinery/equipment); capital (the terms of the loan and down payment); and conditions (which cover the loan term).

Those applying for a farm ownership loan through USDA must demonstrate farm experience, which can be obtained through education, university or Extension classes and/or practical farm experience.

Aspects to consider when borrowing money include not maxing out lines of credit – the lender won’t necessarily extend if there’s cost overrun.

“Capitalizing operation losses is a big one we see in agriculture, particularly with older farms,” said Laughton. “This happens when you have a bad year, can’t pay bills and borrow money to pay bills. It isn’t unusual for a farm to have a bad year and do this, but if you start doing it often, farm equity will erode.”

He advised not financing two years beyond the useful life of an asset to be prepared to purchase updated equipment.

Laughton offered suggestions for successful loan relationships, including building and maintaining a credit score above 670, reducing or eliminating credit card debt, building working capital, building history through filing Schedule F and retaining offfarm employment for a while. He also said everything takes longer than anticipated and advised against adding enterprises until the first is mastered.

While one lender might decline a loan, Laughton encouraged farmers to keep trying. “Look around and see what your options are,” he said. “If one lender says no, another might say yes. Don’t be discouraged based on the first place you go.”

by Sally Colby