Farm Management Update, April 1997
By David M. Kohl, Dixie Watts Reaves, Troy Wilson, and Amanda Wilson
Agricultural producers must be aware of changes occurring in the ways that agrilenders analyze credit. Historically, agrilenders analyzed loan requests without regard to the size of the loan or operation. However, in recent years with the emergence of technology and increased competitive pressures, lenders are streamlining the process, particularly on smaller agricultural loans. For discussion purposes, small loans will be considered as those loans made to producers with business revenue less than $100,000 annually and a large dependence on non-farm revenue.
The following is a case situation illustrating the process of small loan analysis. It can provide insight into the types of information used and the extent of the analysis performed by lenders. Some lenders will modify the process, depending upon institutional policy and requirements.
In analyzing smaller loans, lenders tend to focus on three key areas. First, they analyze the borrower's ability to repay the debt on a timely basis. Second, they determine whether the bank is collateralized and secured. Third, they examine credit history and credit card use to obtain an historical track record of repayment.
The farm in the following case study experiences small farm profits or losses, depending upon the year. There is considerable dependence on non-farm revenue to make payments and support family living. The basic information needed for the analysis comes from the balance sheet, W-2 wage forms, and the Schedule F tax form.
Repayment Ability
Increasingly, lenders are analyzing repayment ability by the debt payment/income ratio, which measures debt payments as a percentage of capacity. Capacity is farm and non-farm earnings before interest and depreciation. Examining Worksheet 1 in Exhibit 2 shows that the debt payment/income ratio for our case study customer ranges from 25-35 percent.
Most agrilenders consider a ratio under 25 percent a low risk, 25 to 50 percent a moderate risk, and above 50 percent a high risk. The risk increases as the ratio increases, because it indicates less margin remaining after debt payments for family living, income taxes, and other investments. Recent research conducted by David Kohl, Department of Agricultural and Applied Economics at Virginia Tech, found that when this ratio exceeds 40 percent, the incidence of credit repayment problems increases 4 times. However, in some cases, families having a ratio exceeding 50 percent still had timely repayment resulting from modest living standards.
Debt Levels and Collateral
The second area of analysis focuses on financial leverage and collateral. A typical measure of leverage is the debt/asset ratio. The case example producer has a debt to asset ratio ranging from 39 to 50 percent (Worksheet 2, Exhibit 2). On smaller loans with greater dependence on non-farm income, a level under 50 percent represents a low risk, 50 to 75 percent a moderate risk, while over 75 percent a very high risk. Some lenders will examine collateral coverage ratio. This ratio compares the value of pledged collateral to the amount of the loan. In the case study situation, the ratio ranges from 1.70 to 1.89. Interpreting this ratio, there is $1.70 of assets at market value for every $1.00 of liabilities pledged against those assets. A ratio greater than 2.00 indicates a strong collateral position for the lenders. As the ratio approaches 1.00, the lender's risk increases because of the possibility of the need to sell assets in the absence of sufficient repayment ability.
Track Record
Lenders are placing increasing emphasis on the area of credit history. A recent study by J.R. Marker found that nearly 80 percent of people with late repayment were doomed to repeat the pattern. The reader needs to be aware that credit histories and reports can frequently be flawed with false information. It is suggested that a credit history check be completed every two years to determine the accuracy of the report. This check is very critical following hospitalization, divorce, death, or other emergencies where there is an increased probability in delayed paperwork on repayment. Lenders will also examine courthouse files and local suppliers to determine repayment characteristics. Individuals wanting to examine their personal history can request a report through the local credit bureau, or other national organizations that collect such data such as Equifax (800-685-1111), Trans Union (216-779-7200).
In addition to general repayment history, lenders are placing more emphasis on credit card debt and available credit limits. This debt is unsecured and frequently a sign of an extravagant living styles or insufficient earnings to cover expenses and debt. Careful attention should be paid to limits on credit cards, as most lenders consider limits rather than balances. For example, if a producer had a $20,000 limit, the lenders would consider this amount, even if the balance is paid down to zero on a monthly basis. They will also examine credit card usage by spouses and include it in the analysis.
Credit Scoring
More agrilenders and organizations such as cooperatives and equipment leasing companies are utilizing credit scoring. A credit scoring system is illustrated in Exhibit II. Some institutions are providing a 30-minute turn-around time on a small loan request if proper information is provided. As illustrated in Exhibit III, the case study customer has a high total score, which enables the individual to receive a more competitive rate. This system illustrates how the score is determined and weighted with the various ratios and other criteria. A recent study found that well over half of all lenders are using systems like the one illustrated on some of their loans. It is important for the producer and the consumer to be aware of these systems and the criteria and weighting that are utilized.
In the future, credit requests will be more automated and will require less paperwork. It is important for the consumer to be aware of these factors in order to obtain credit on a timely basis.
