The cost squeeze has livestock farmers in a stranglehold, and a new drought is looming in parts of South Africa and Namibia. Avoid these financial pitfalls if you’re struggling.
By Louis Du Pisani
1. Loans with repayment terms that are too short or too long
The repayment term of a loan should align with the lifespan or useful life of the asset being financed. Farmers commonly make two mistakes. One is financing a medium- or long-term asset with a short-term loan. The other is buying a short- or medium-term asset with a long-term loan.
A longer-term project, such as developing irrigation for grazing or fodder production, only delivers maximum returns after some time. The income stream is initially slow and increases over time until the grazing reaches full production.
The loan must therefore match the production rhythm of the irrigation system. The shorter the loan term, the higher the annual repayment will be. A project that generates income slowly and only reaches full productivity later will put cash flow under pressure. The shorter the repayment period, the greater this pressure becomes.
Longer-term loans are usually secured with a mortgage over long-term fixed assets, such as land. This is a relatively time-consuming and costly process. Farmers therefore often take shortcuts by using short-term capital, such as production loans and bank overdrafts, to finance long-term assets and projects. The solution is to consolidate these short-term loans and refinance them over a longer period, which provides relief for cash flow.
Banks are generally reluctant to extend loan terms for certain projects beyond specific limits. Farmers often accept these terms because they are eager to start the project.
Farmers also sometimes finance equipment over too long a period to make repayments more affordable. The result is that when the equipment needs to be replaced, the loan has not yet been paid off. This is particularly a problem when vehicles are financed with a so-called balloon payment.
2. Over- and under-capitalisation
Over-capitalisation occurs when the assets acquired for a project are more expensive than the project can justify, or when more assets are purchased than are actually required.
An example is when a farmer lambs 200 ewes per month in lambing pens, but has pens for 400 ewes. Another example is buying haymaking equipment worth R250 000 for a 5 ha lucerne field that can only be irrigated part-time, or purchasing a four-wheel-drive bakkie for a farm where it is not needed.
Over-capitalisation often takes place shortly before the end of the financial year, especially when it appears that the farm may have to pay tax. A common consideration is to make capital purchases that are deductible for income tax purposes.
Undercapitalisation occurs when a farm’s production capacity is limited by a lack of equipment, infrastructure and other inputs. The farm therefore never reaches its true profit potential. A classic example is a farm with unused or underused water and water rights, available irrigation land and a favourable climate for fodder production. The reason for under-capitalisation is often earlier over-capitalisation or weak performance in another part of the farm, which results in loan applications being rejected on merit.
Also read: Beyond the business plan: AFGRI’s Praveen Dwarika challenges farmers to invest in themselves
3. Paying debt with debt
Paying debt with debt often happens without the farmer realising it. A large debt burden puts profitability under pressure and leaves little room for the farmer’s own financial needs. What to do then?
Farmers often cover this personal shortfall by using the farm’s overdraft facility. In this way, debt is indirectly being repaid with more debt. An overdraft facility that increases year after year is usually a sign that this is happening.
4. Overoptimistic expectations
It is essential to test the economic viability of a project thoroughly against its most important risks. The three major risks to which farms are most exposed are droughts, volatile product prices and changing interest rates. It is not sufficient to evaluate a project’s viability only against average years, current product prices and current interest rates.
It is always advisable to prepare different scenarios to determine how viable the project would be during drought years, periods of low product prices and high interest rates.
5. Poor business plans
Loan applications with strong underlying financial merit are often rejected because of poorly prepared business plans. A well-constructed and credible business plan builds trust with the credit provider.
A credit provider must ensure that the credit risk associated with a loan remains within acceptable limits. Credit providers make their revenue from loans that are repaid regularly. They are therefore primarily concerned with the applicant’s ability to repay the loan. They then consider whether there is sufficient security should the loan not be recoverable.
Banks look at several aspects of a business plan:
- The applicant’s financial history. The business’s balance sheet, overdraft history and previous loans all play a significant role.
- The applicant’s management profile. Factors such as training, experience, passion, integrity and management skills are taken into account.
It is always useful to include such a profile in the business plan.
- Repayment capacity. This includes credible multi-year budgets, worst-case scenarios in which the three major risks are factored into the budgets, management plans showing how the project will be launched and managed, what risk-management measures will be implemented, how progress will be monitored and a SWOT analysis of the project.
- Available security
Also read: Business registration and structuring for farmers: All you need to know
6. Expansion of the farm
A stagnant farm is effectively in decline due to the effect of inflation. Expansion is therefore essential for any farm. However, two truths apply when expanding a livestock farm.
First, do not expand the farm before the existing operation is performing well. Second, a livestock farm is vulnerable when expansion happens faster than its cash flow can support.
A farm should only be expanded once the current operation has reached full capacity, productivity and profitability. There is no sense in expanding a business that is struggling.
Good habits and strong management skills are required to make a farm truly successful. No one wants to buy more land or start a project that will also be managed poorly.
Over-expansion of a livestock farm can be compared to an avalanche. It starts slowly, then gains momentum until it turns into a full-blown storm.
There is only one way to prevent this. Set short- and long-term goals for your farm, write them down and put them where everyone can see them. Otherwise, they will remain nothing more than a wish list.
Research has shown that people who write down their goals have a 42% greater chance of achieving them. Those who share their goals with others have a 78% greater chance of succeeding.
7. Needs vs. wants
In his book The Richest Man in Babylon, businessman George S. Clason writes “people’s needs increase in proportion to the increase in their income”. In practice, this means that people often confuse needs and wants.
Make sure that spending on a project, equipment or anything else is motivated by what is essential for success, and not simply something that will impress other people.
Also read: Building credible and investment-ready agribusinesses: Insights from industry leaders
