Farmers, like all business owners, have three forms of credit available to them: short-, medium- and long-term debt. Managing these, and dealing with your tax obligations, can often be critical to the sustainability of your farm, says veteran Merino farmer Claude Cloete.
Short-Term Debt
This form of credit is used for the day-to-day running of the business, and is usually a bank overdraft or production loans from cooperatives and agribusinesses. This is usually the most expensive form of debt, and interest is normally calculated daily.
At least once a year you should bring your short-term debt to zero, or, even better, to a positive balance in the bank. If this is not happening on a regular basis then your farming practises or methods are not sustainable over the long term. You are simply doing something wrong, and waiting for better times is not going to solve the problem!
A bigger overdraft or production loan will not solve the problem. The temptation is always there to increase production through increased inputs, and therefore more debt.
Refer to the graph below: if a farm is at the point of maximum profit, increasing inputs will only reduce profits. Throwing money at a problem very seldom, if ever, works.
Also read: Death, debt and divorce – These cause great hardship on farms
A growing overdraft is a symptom of management issues, like farming with the wrong type of animal or growing the wrong crop for the region.
Medium-Term Debt
This type of debt is used to buy animals, machines, irrigation equipment and vehicles. These are usually financed over three to five years. It is not advisable to use a bank overdraft to finance these purchases.
When using this form of debt, it is important to distinguish between needs and wants. This form of spending is where most problems occur in a business, as there is often ego involved. It is surprising how few machines a farm really requires. A farm bakkie is a workhorse, not a status symbol.
Having said this, when buying farm machinery that you really need, it is better to finance it rather than pay cash if the business will experience cash-flow problems if payment were made in cash. Common sense always needs to prevail.
Problems usually arise because you buy something just because finance is available. You need to think about what you need as opposed to what you want. A salesman will sell you your own house if he could, and the bank would finance the deal!
All farms and businesses need to have a sound replacement or upgrading policy. It is no use waiting until all the machines are broken and then having to replace everything at once.
If a farm has 20 machines, it is necessary to replace at least 2 machines a year, given a life expectancy of 10 years. This needs to be carefully planned and budgeted for. It is a very important cost of doing business. Critical machines cannot break down at critical times.
The problem with many agricultural machines is that they work for one month of the year and stand in storage for the other 11 months. It is important that when machines are bought that they are really needed in order to justify the fixed cost of standing in a shed.
Long-Term Debt
This type of debt is money used to expand the business. Very few farmers can buy the neighbouring farm and pay cash. This is where long-term loans come into play.
Also read: Tax compliance for farmers: What you need to know
Such loans are payable over 10 to 20 years, and there is usually a bond involved. They normally have a lower interest rate than medium- and short-term loans.
Debt as such is not a bad thing, and in most businesses it is a necessary evil. Expanding a business is impossible without some form of debt, but remember, buying an extra tractor is not expansion if the farm were running fine without that tractor.
For a sheep farmer, borrowing money to buy more sheep is also not expansion, unless he has also bought more land, because a sheep farmer should be able to breed up his numbers himself. Borrowing money to buy sheep to put on rented land gives close to a zero return.
Tax
If a business pays income tax on a regular basis it will never go bankrupt. In the same way, if you never pay income tax, you will eventually go bankrupt. There is only one way to avoid paying tax and that is to spend more than you earn, and that’s usually by making more debt.
I speak to many people with an absolute fear of paying income tax, and it seems as if they regard it as a sign of weakness.
There are many ways to minimise the impact of tax, but spending R100 to save R30 in income tax is not the way to go about it.
This is where a qualified accountant comes into play. The tax system is written in such a way to keep you in business. It would be no good if those paying tax were to go out of business. The government would be killing their source of income. The fact that the government wastes our tax money is no reason for you to sink your business.
All countries have similar tax systems with similar goals. First-world countries generally have higher tax rates than third-world countries.
All debt is paid with after-tax money, and this is what makes expanding so difficult. You pay off a bit of capital each year. This leaves you with cash-flow issues, so you must borrow money to pay the income tax. A cycle that tests and moulds your character.
Many people solve this problem by expanding their operation. They aim to grow the business faster than debt can grow. This is all well and fine, but at some time the debt will have to be paid.
Also read: Debt ratios: How to stop your ship from sinking
Beware the three D’s that can derail a business: death, divorce and debt. Banks become very sticky with this mix.
If your aim is to pass on your farm to the next generation, then it is critical that debt issues are sorted out, otherwise the problem merely becomes theirs. If that is your plan, then fine, but your son or daughter should at least know about the plan. Death is a very expensive business if proper provision has not been made.
Sustainability
Lastly, a word about being sustainable. It’s one of the most used and misused words in recent times. The simple fact is that you are farming sustainably if you are not making a profit and your farm will continue until your run out of capital the bank can use as security.
There is that famous quote attributed to Einstein: “The most powerful thing in the world is compound interest.” Remember, with debt it works against you, but with cash it works for you!
