Farm business: getting finance and speaking to your bank manager

Find out how to get finance for your farm business and what you’ll need to do before approaching a lender.

Gone is the time of judgemental lending where a bank manager would visit a farm to approve new loans. There are now financial measurements and ratios to be met leading to more responsible lending.

Therefore, it’s important to understand what amount is sensible to borrow and what boxes need to be ticked for approval. It’s more difficult to ask a second time once an amount has been turned down already.

The three key areas are:

• serviceability
• security
• succession

Serviceability can be very simplistic. For example, can the business afford £3,000 a month to finance debt?

However, on many farms, there is not just the new loan to consider but existing commitments such as hire purchase agreement repayments and/or existing bank debt repayments.

Lenders will assess serviceability by taking your last or budgeted business profit, adding back your finance and depreciation costs, and taking off your personal drawings. This gives the lender a figure they call EBITDA (earnings before interest, tax, depreciation, and amortisation).

They will then calculate your yearly capital and interest repayments on all your finance agreements and then divide over the ‘EBITDA ‘over this.

This gives you a debt service ratio. Most lenders look for this to be over 1.5 times, meaning you can afford the annual borrowing costs each year 1.5 times over.

The margin of 1.5 times over allows for fluctuations in the markets and prices.

This is a calculation that most can complete on farm or with the help of an advisor. The outcome of this calculation will show if the farm is in a comfortable position to ask for funding or whether it would leave your finances too tight.

When doing this calculation based on prior year performance, it is important to consider how the expansion or project will affect the future financial performance. For example, if you are looking to purchase a block of land you already rent, the rental payment will be saved and you can adjust your profit to reflect this.

Many lenders also now stress test the lending, too. This means they test whether you can repay the borrowing if the Bank of England base rate is increased. Often lenders will stress test all your borrowings to 6% to see if you would still be able to meet the annual repayments at this point.

How risky is the borrowing for the lender? In the majority of cases capital value will not be an issue.

In some businesses such as tenant farming, operations security may be an issue. It is therefore important to consider the level of exposure to the lender.

The easy way to look at this is by completing a loan to value (LTV) calculation Whereby you divide your total finance amount by your land and property value. For example, a business with a bank debt of £750,000 and a land/property value of £2,100,000 would have a LTV of 35%.

Lenders such as the Agricultural Mortgages Corporation will only lend to up to 60% LTV whereas high street banks will go higher.

Another important consideration is the security already given to other lenders, as some lenders will only accept the first charge. For example, if you had an agricultural mortgage on the farmland, you may not be able to use this as security for separate project finance.

Often finance obtained from a lender is over a long-term over 10-15 years. It’s important to consider all those involved in the business, including those who will be making decisions and repaying these loans in the future.

For example, changing a milking parlour may have a return over 10 years so it is important to have the next generation, who may be responsible for making repayments in the future, involved in the decision making.

For example, in a two-generation farming family where parents are in their 70s and the next generation are looking to take control of the business, 50 a lender may not wish to give a term greater than 15 years, unless there was a third generation. This is because in these circumstances, the business is unlikely to sustain its profits for the length of the loan without employing extra labour.

If you would like to learn more about what your bank manager's requirements, listen to this webinar with Neil Wilson. He discusses how to prepare for a meeting and explainsthe acronym CAMPARI that bank managers use to assess proposals. CAMPARI includes an assessment of:

• Character
• Ability
• Means
• Purpose
• Amount
• Repayment
• Insurance

Farming businesses can become short of cash and refinancing borrowings over a longer term will help cashflow. For most cases, this is because the original borrowing was taken out over too short a term.

Getting the term right

When taking new borrowing, it is important to consider the appropriate borrowing terms for both the asset being purchased, or invested in, and the business.

It is often the case that the asset purchased and financed suits a longer term of lending. If financed on shorter terms, the business cannot afford the repayments after considering other areas of reinvestment that are needed for the business.

Where borrowing is taken out over too short a term, it often results in the business increasing its overdraft of having to fund more machinery reinvestment on hire purchase agreements. Hire purchase agreements often make this problem worse as the monthly cash commitments continue to degenerate cashflow.

Example:

Home farm plans to purchase an additional 45 acres for £360,000. This land is usually rented each year therefore there will be a minimal saving of £6,500.

The business doesn’t have any cash to buy the land and is therefore considering its options for financing the land on a commercial loan. The bank has come back with the following options for the business:

Captial repayment and interest:

We can consider how long the term of the funding should be based on the asset and business.

The asset

The asset is farmland. Farmland would suit longer term lending as its life is infinite, compared to a depreciating asset. Farmland historically has always risen in value and therefore long-term borrowing should not affect the residual value. This would mean based on the asset the lending should be 20 years and over.

The business

We do not know the profitability of the business but, on the basis that the bank is offering all lending terms, we can assume it is very profitable and generates a cash surplus each year. However, the business has no cash to invest in land therefore must be using this cash surplus to reinvest in growing the business.

As the land purchase will only result in a cash saving of £6,500 of rent, the majority of the cash for the repayments will have to come from the existing business. The business would therefore suit a longer term of 20-30 years.

In summary, the new borrowing should be on at least a 20-year term.

Instead, often businesses choose to repay the debt over 10-15 years. Each of these terms when compared to a 25-year term would adversely affect cash requiring an extra £763 or £1,745 per month.

The barrier to taking a longer term is often extra interest payable. However, you should back your business to gain a better return on the short-term cashflow savings, rather than repaying the loan quickly and risk your business being starved of cash for reinvestment.