The answers to a dozen questions will help develop the documentation needed in a loan package or a business plan. These are business-oriented questions that should be addressed from a risk management standpoint:

  1. How much money will you need? Not just initially, but over the period of the loan. Lenders do not want to loan an amount that they feel comfortable with and then suddenly learn that significantly more money is needed to see the situation through to completion. Estimates of repayment ability should be realistic and conservative. Revenue and cost estimates need to address typical contingencies.

  2. What will the money be used for? Be specific. It's not enough to say “operating expenses.” Too many operating loans have been used to subsidize lifestyles, refinance and/or pay carryover debt and finance capital purchases. Support your plans with budgets and documentation that reflect past experience. Too often, projections appear to be based on realistic estimates, but further review exposes performance levels that are out of line with what the business has been able to achieve in the past. If you're projecting improved performance, you need to be able to demonstrate how and why.

  3. How will the loan affect your financial position? It is obviously important to know what your net worth, financial structure, historical cash flows, profitability and risk exposure are at the time of the loan request. But what will things look like after the loan is made? Will your risk profile — in terms of working capital, leverage and debt repayment capacity — change materially?

  4. How will the loan be secured?

    It is critical to recognize that collateral is adequate only if, under the worst conditions, enough value could be collected to generate sufficient cash to repay the loan and cover all costs. Except for control purposes, the primary purpose of collateral is to provide insurance in the event of default. Therefore, the important lending consideration is not just what the collateral is worth at the time of the loan request, but also what the expected value is at the due date or at the date of the next scheduled payment.

    The lender needs to account for the period of time involved, potential changes in collateral condition and value, legal and selling costs, and the fact that a distress sale will bring less than an arms' length transaction under normal market conditions.

    The changing nature of security has become one of the most significant factors affecting agricultural lending. More loans are now dependent on both soft and hard assets (i.e. key personnel, contracts, leases, etc.). There are also more joint ownership arrangements and market risks related to specific attribute raw materials rather than straight commodities. All of these make it more difficult for the lender to assess a net realizable value. For perspective — what's an empty hog building really worth today?

  5. How will the loan be repaid?

    Will repayment come from operating profits, non-farm income, the sale of the asset being financed, refinancing or from the liquidation of other assets? How predictable and dependable is the source of repayment?

  6. When is the money needed and when will it be repaid? This two-part question should be answered by the projected cash flow budget. Answering this question ensures that you and the lender both know how the business operates. Almost as many credit problems have resulted from a lack of understanding and communication as from unrealistic expectations. Marketing plans and trigger points, contract terms and conditions, and various pooling arrangements are often not adequately communicated or documented.

  7. Are your projections reasonable and supported by documented, historical information? Too many producers still do not have production, marketing and financial records to demonstrate their track record and support their projections. It is extremely important to be objective in cash flow projections, not just for the lender, but also for the borrower's management purposes.

    One study of farm borrowers spanning several years found that, on average, they overestimated cash receipts by 15% and underestimated cash expenditures by 17%. If these errors were purely a function of market and production variability, revenues should have been underestimated as often as they were overestimated. The same should have been true for expenditures. There is a tendency toward too much wishful thinking and a lack of adequate planning in the development of cash flow projections.

  8. If the outcomes change, will it affect your repayment ability? Due to the numerous factors affecting production agriculture, cash flow projections frequently vary from the actual outcome. It is important to make sound projections and analyze “what if” scenarios.

    Even under marketing and production contracts with established price bases, quality premiums and discounts can result in a great deal of uncertainty. The most frequent error occurs when borrowers and lenders believe they are addressing the issue, such as the impact of a 10% decrease in revenues. For some businesses, this practice overstates the risk; for others, it may seriously understate the potential risks.

    Done correctly, the alternatives considered should reflect the business's actual historical performance variability, as well as the range of current forecasts. While nearly all farmers and ranchers are on a cash basis for income tax purposes, most lenders will adjust this information for changes in inventories, accounts receivable, accounts payable and accrued expenses to get an estimate of income on an accrual basis.

    Many lenders are requiring borrowers to provide annual accrual basis income statements — and more will be — because while cash basis income accounting is valuable for income tax management, it is often a very inaccurate measure of business performance. Cash basis income can lag accrual income by as much as two years in detecting upturns or downturns in profitability.

  9. How will you repay the loan if the first repayment plan fails? No commercial lender wants to be in a situation where foreclosure is the only alternative. Contingency planning is critical. Recognize what could go wrong and what you plan to do if it does. Every plan should have a backup plan and every entry strategy should have an exit strategy. This is particularly true where niche markets or new ventures/enterprises are involved.

  10. How much can you afford to lose and still maintain a viable operation? First, recognize that a viable net worth is not anything above zero. Most commercial lenders require some minimum equity position (e.g. 40%), below which they will not continue financing without an external guarantee. Therefore, the answer to the question must be based on the effect of various combinations of potential operating losses and declines in asset values. Lenders call this “shock testing.”

  11. What risk management measures have been or will be implemented? This can cover everything from formal risk management tools to management strategies. The major point is to make sure the borrower and the lender understand how these measures work. For example, incorrect use of commodity futures and options can increase rather than reduce risk. It is also critical that the lender is supportive and committed. A lender's unwillingness to finance margin calls can destroy a successful hedge.

  12. What have been the trends in the business' key financial position and performance indicators? The first issue is: do you know the trends? The second, if the trends are adverse, what are the specific short- and long-term plans for turning things around? If you plan to keep doing what you've been doing and hope things get better, you're setting yourself up for a rejection. Timely action, willingness to change and the ability to manage problems are hard to measure, but as risk increases, they are critical in the credit decision process.