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3 open minutes with Chris Laughton

Progressive Dairyman Editor Dave Natzke Published on 09 March 2017

After raising the benchmark interest rate just once in seven years, the Federal Reserve increased the rate 0.25 percent in December 2016 and hinted three similar increases may be coming in 2017.

Progressive Dairyman Editor Dave Natzke asked Chris Laughton, director of Knowledge Exchange for Farm Credit East, based in Enfield, Connecticut, to discuss dairy farm business management in an environment of rising interest rates.

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Chris Laughton

 

 

Chris Laughton
Director of Knowledge Exchange
Farm Credit East

 

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Q. How is money (a loan) priced to farm borrowers?

A. It may be helpful to briefly review how interest rates on loans are set:

  • The borrower’s interest rate on variable-rate loans fluctuates with their lender’s cost of money. Variable rates float with the market and may be tied to the lender’s index of cost of funds, the Prime Rate, the London Interbank Offered Rate (LIBOR, an international benchmark) or some other external index.

    Regardless of the index, most variable loan rates follow the Federal Reserve’s interest rate, changing nearly instantaneously and proportionately.

  • For fixed-rate loans, the rate is set at the time the loan funds are advanced, for either the life of the loan or some other fixed period of time, i.e., one year, five years or perhaps 25 years. As the term “fixed” indicates, these rates are not impacted by changes in Federal Reserve rates.

Operationally, this is no different than how many other farm inputs are priced. Take soybean meal, for example. A producer may choose to purchase soybean meal on the open market at today’s spot market price – this is akin to variable rate pricing.

Or they may elect to forward-price purchases in the future, locking in their cost and isolating themselves from further market moves – fixed-rate pricing.

Most farm borrowers have some combination of variable- and fixed-rate loans, resulting in a blended interest rate paid for all debt. The greater the proportion of variable rate debt, the more the blended rate will fluctuate directly with the Fed rate.

Q. How do Federal Reserve actions impact Farm Credit’s cost of funds?

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A. Farm Credit obtains its lending funds primarily by selling bonds and discount notes to investors in the Wall Street money markets. The Farm Credit System’s cost of money for short-term instruments follows the Fed rate very closely and pretty much instantaneously.

So when the Fed increases the rate by 25 basis points (0.25 percent), the Farm Credit System’s cost of short-term money increases by a like amount within days. At Farm Credit East, we typically wait until the first of the following month to increase our variable interest rate to our borrowers.

Q. If borrowing in 2017, how should dairy farmers prepare for rising rates?

A. Developing an annual detailed operating and cash flow budget for the coming year is a best practice for all dairy farm businesses. With volatility in milk prices and input costs, a business operator is “flying blind” without the discipline of developing a detailed budget and then monitoring it monthly throughout the year.

In this year’s budgeting, variable-priced loans must also be adjusted for the expected increases in interest rates, and this could show a significant increase in interest cost for 2017. This could in turn impact total expenses, net earnings (profit) and total debt payments, depending on the individual circumstances of the business and their debt structure.

In planning for capital spending and new debt this year, we also encourage updating a capital spending analysis and priority list. That said, even with interest rates poised to increase by 1 percent by year-end, the projected increase is not likely to change the decision of which capital items to invest and how much debt to incur.

Q. Are there differences for how farmers should manage new or existing operating, intermediate/machinery or real estate loans?

A. We encourage our dairy borrowers to “keep it simple” in terms of debt structure:

  • An operating line of credit should be used for current operating expenses such as crop inputs, purchased feed and perhaps tax planning at year-end.

  • A capital line of credit should be used for machinery, equipment, dairy cattle and other intermediate-term asset acquisitions with useful lives of up to 10 years.

  • Real estate mortgage loans should be used to finance acquisition of farmland and major projects such as barns, milking centers and manure storage.

From the borrower standpoint, this focuses attention on all debt on the balance sheet rather than a multitude of individual loans. Unused operating and capital lines of credit are easy to track. That information also gives the borrower the ability to negotiate best prices on everything they buy by being able to pay the vendor “cash” on delivery.

With this credit structure, we encourage borrowers to understand their blended capital debt term: the number of years it would take to fully repay all of the capital and real estate debt outstanding at the current repayment schedule.

The ideal number is unique to each dairy, based on what is being financed with debt, its earnings, the proportion of the various asset classes (equipment, livestock, real estate, etc.) on the balance sheet and its overall financial strength. For most successful dairy businesses, it is eight years or less.

Q. Dairy margins are forecast to improve in 2017. At the same time, 2015-2016 resulted in some erosion of available cash and equity positions for many dairy farmers. As a lender in this dairy environment, what do you tell potential borrowers?

A. Your premise is very appropriate. Dairy farms here in the Northeast have experienced substantial erosion of liquidity and slower repayment of debt due to sharply lower prices and margins. With price forecasters somewhat more positive for 2017, we encourage our borrowers to think seriously about rebuilding/right-sizing their balance sheets.

Certainly, if they have accumulated debt to cover operating deficits, this needs to be aggressively paid down. Most dairy businesses have also sharply curtailed capital spending in the past two years, and we recognize there will need to be some catch-up in replacement of highly depreciable machinery.

Q. Are there any key metrics you look at?

A. We and most of the rest of the dairy industry have historically focused on debt per cow as a financial metric. There is so much variability among farms in terms of net earnings, however, that proposing a single benchmark for debt per cow is not particularly useful. Year-to-year volatility of net earnings further diminishes the usefulness of debt per cow as a benchmark.

We encourage folks to focus on Debt-to-EBITDA (earnings before interest, tax, depreciation and amortization) as the best single metric for understanding appropriate debt/debt service levels. Your farm records specialist or business consultant can readily assist you in calculating this metric. The calculation is:

Debt to EBITDA = total liabilities / average EBITDA for 3 most recent years

Generally, businesses with debt-to-EBITDA below 5.5 are in pretty good shape. Those above 5.5 need to take bold action in their businesses to become better positioned, either through improving net earnings, selling assets to reduce debt or some combination of both.

Those above 8.0 are likely in a financial danger zone and should take immediate action with their professional team of advisers to improve.

Q. Are there some bedrock things related to borrowing that transcend interest rates?

A. Matching repayment to the useful life of the asset is critical.

We cannot overemphasize the importance of having accurate, real-time financial records to track your business month-to-month, year-to-year. Your records specialist, business consultant or accountant should assist you in ensuring you can evaluate on both cash and accrual basis.

Understand your credit capacity, both in terms of how much your lender currently has approved for you and what their position would be if you came back for more.

We have a saying, “We never want to lend a borrower’s last dollar.” That means that we want to maintain the capacity to lend additional funds to assist with contingencies, such as the sharp downturn in milk prices or a major drought.

When that next opportunity arises, like the farm next door comes up for sale, we would like for our borrower to be positioned for us to say “yes” to financing it.

Q. Any other points that need to be considered?

A. Work closely with your lender. Constant communication is key whether things are headed up or headed down. Ask about interesting rate pricing options. Share your “long view” with your lender and ask them their “long view” as to your lending relationship.  end mark

Dave Natzke
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