Financing Agruicultural Operations: The Loan Process in California
by Steven C. Blank, Extension economist, University of California, Davis
California agricultural producers face a different agricultural credit market in the 1990s than the market existing earlier. Lenders have changed, the loan process has changed and, as a result, agricultural producers have had to change the way they go about acquiring the credit needed to sustain their operations. Underlying the changes in the credit market is lenders' increased attention to profitability and risk. The profitability and riskiness associated with each of the state's 250 commodities varies across markets. Thus, agricultural loan analysis can lead to differing results across products and locations. To provide insight as to how loan officers face this challenge and what it means for producers when seeking a loan, this article summarizes the findings of a survey of agricultural lending practices.
The results reported are derived from the responses of 40 randomly selected lenders. The sample included personnel from 20 commercial banks, 13 Farm Credit System (FCS) institutions, three life insurance companies, two Farmers Home Administration (FmHA) offices, and two processors/marketers who lend to growers. Twenty-one of the 40 interviewees were loan officers, nine were branch managers, and 10 were regional vice presidents.
The Loan Process
Lenders were asked to describe the loan process and the documents they require from a borrower. A summary of those responses follows. The process begins with initial contact between lender and borrower. The next step is completion of an application and package. A field visit is usually scheduled, often conducted by a specially trained field person or appraiser. The loan officer completes his/her analysis and, in most institutions, can grant the loan if it is within his/her delegated authority. Most institutions utilize a loan committee to evaluate the largest loans. The average turn-around time for a short-term loan was reported to be 22 days after the borrower completes the package. For long-term loans, the average was 52 days, because the appraisal can cause delays and in most cases a commitment is made contingent on the appraisal. Most large banks and FCS institutions usually have in-house appraisers while small banks usually hire fee appraisers.
The documents required from borrowers were largely consistent between lenders. Three years of tax returns, a current income statement, a market value balance sheet, and a cash flow budget were the standard documents required. However, for real estate loans, environmental questionnaires were required. In areas where water was a concern, a water questionnaire, a water plan, or well tests also were often required.
Half of the lenders interviewed said that the loan process has changed recently. Some of the changes mentioned were a greater use of computers, stricter verification of information, separation of the appraisal and loan analysis functions, and increased requests by lenders for accrual financial statements.
To identify the loan analysis criteria (i.e. underwriting standards) used in the field, lenders were asked if they used any of 11 financial ratios and if they had specific standards. The results indicate that no one ratio determines whether or not a loan is granted. The decision is based on a combination of several variables, some of which are subjective in nature. Table 1 lists the ratios and responses.
From the table it is clear that the heaviest use is made of just four financial ratios: debt-to-equity, loan-to-value, the current ratio, and the debt coverage ratio. The debt coverage and current ratios address the question of repayment capacity. The loan-to-value ratio deals with strength of collateral. Debt-to-equity (a.k.a. the leverage ratio) shows the level of financial risk carried by the borrower. Profit margin is also considered by over half of the lenders in the sample and it measures business performance. Only five respondents mentioned standards for profit margin. Two others pointed out that they had no absolute standards for profit margin, but they did like to see it on an upward trend. The other ratios (debt-to-asset, intermediate, percent of return on assets and equity, times interest earned, and asset turnover), though recommended by the Farm Financial Standards Task Force and found in agricultural finance textbooks, were not widely applied in loan analysis by the lenders interviewed.
Table 1. Financial Ratios and Standards Used by California Agricultural Lenders
|Debt-to-Asset||15||<0.5:1||<0.5:1 to <0.6:1|
|Debt-to-Equity||93||<1:1||<1:1 to <4:1|
|Loan-to-Value||88||<65%||<60% to 100%|
|Current Ratio||93||>1.5:1||>1.1:1 to >1.5:1|
|% Return on Assets||35||none|
|% Return on Equity||35||none|
|Times Interest Earned||13||none|
|Profit Margin||60||>20%||>15% to >30%|
|Debt Coverage Ratio||93||>1.25:1||>1.1:1 to >1.4:1|
The greatest variation between standards occurred in the current ratio for which almost as many lenders used a standard of greater than 1:1 as used standards of greater than 1.25:1 or greater than 1.5:1. The least amount of variation in standards was observed for the debt coverage ratio. Sixty-six percent of those expressing a standard for the debt coverage ratio said that it should be greater than 1.25:1.
The qualitative factors considered in loan analysis were reported to be management ability, character, reputation, credit history, risk factors, appearance of the farm, good records and financial data, asset quality, analysis of the industry, and a farmer's knowledge of his business. Obviously, the factors on this list are not mutually exclusive. When asked to elaborate on what to look for when judging management ability, the lenders again mentioned the appearance of the farm, the borrower's knowledge, the quality of financial data submitted as well as production and financial history.
Lender's Reaction to Risk
Seventy-five percent of the lenders said "yes" when asked whether the riskiness of the commodities produced by the borrower alters the loan process. They reported that risk could make a difference because underwriting standards (especially the loan-to-value ratio) can become stricter on risky commodities. Also, riskier loans will be priced at higher interest rates. The main change in the loan due to risk was a tightening of loan requirements, mentioned by almost 60% of the lenders. Several lenders noted that higher risks meant more work for the borrower to prove knowledge or profitability of a commodity. This implies severe limitations on borrowers without a history of production in that commodity and could slow shifts from field crops to higher value fruit and vegetable production statewide. Other changes in the loan process include higher interest or loan costs (17% of respondents) and a new loan approval process (14%). The latter may be of considerable importance to FmHAs.
Each lender was asked to rank the riskiness of the commodities produced by their borrowers. Vegetables, citrus, tomatoes, melons, strawberries, and grapes were most frequently ranked as the first or second riskiest types of enterprises. Dairy, beef cattle, field and row crops, almonds, and walnuts were ranked as the first or second least risky enterprises. However, the data is inconclusive because several commodities, such as cotton, citrus and almonds, were ranked as most and least risky crops by different lenders. Several respondents noted that it is difficult to consider risk by commodity since, as lenders, they are more familiar with analyzing the riskiness of a borrower's total operation, which is often diversified.
In summary, interviews with California agricultural lenders pointed out that differences in the degree of risk associated with the income from production of a commodity, is a major factor influencing the loan analysis process. The perceived riskiness of a commodity can lead to stricter underwriting standards and to higher pricing on the loan, but no evidence was found that loan evaluation standards vary across regions of the state or by the size of the farm. Also, loan evaluation standards did not differ significantly between types of lenders. This is somewhat surprising considering the differences in the average loan amounts between lender groups, such as large commercial banks and the Farmers Home Administration. This indicates a strong degree of standardization in the loan analysis process. One form that standardization has taken is in the use of financial ratios. The financial ratios receiving the most use in loan evaluation are the debt-to-equity, loan-to-value, current, and debt coverage ratios. Although there is still considerable variation in the range of standards used in interpreting tools such as financial ratios, it appears that agricultural loan analysis is becoming more sophisticated and is focusing increasing attention on risk.