Agricultural Finance 3 – Acquiring Capital to Farm

Agricultural finance provides the economic principles for analysis of how much it would be profitable and safe to borrow, and the principles or type of information needed to select a lender which best suit the needs of the borrower. However, the final choice of decision on both questions must be made by the individual borrowing the money.

The second area of significance of agricultural finance is the importance of finance in the farm business and the increasing role of credit in the expanding capital requirements of agriculture. Many do not realize the rapid expansion of capital demanded by the technological revolution going on in agriculture nor the consequences which face the farmer who does not “keep up”. Adequate units become in adequate in half of generation if the family does not continue to add capital. Burdened with the load of acquiring the minimum of capital needed to start farming, what chance does the beginning farmer have of ever developing an adequate unit if capital requirements keep growing at a faster rate than he can save?

One solution to these questions may lie in knowing how to use credit and how to get it extended on proper terms. Farmers use credit and will continue to do so, but the significance rests in how much they use, how they use it, and where they obtain it. Where will they obtain credit – from lenders who can help them help themselves, or from lenders who are not interested in their efforts to make progress? Or will they forfeit a portion of their managerial freedom and turn to vertical integration as a means of acquiring capital with which to work? The supply of credit, the terms on which it is made available to agriculture and the knowledge farmers have about how to use it, have great significance for the future. These things might very well determine the future of the family farm. The question then arises: Where can the needed capitals be acquired?

There are seven methods by which farmers may obtain the major part of the capital which they use in their business:

1. Savings
2. Family arrangements
3. Incorporation
4. Leasing
5. Vertical integration
6. Borrowing

1. Savings
Capital accumulated through savings forms the foundation of the farm financial structure. Except for gifts and inheritance, savings provide not only capital, as such, but risk-bearing ability (reserves) and demonstrated capacity to earn and save two very essential components of a strong credit rating.

Farming is a big business and big business requires a large amount of capital and a sound financial foundation and framework which savings alone can provide. Few people who are unable to save will be successful in commercial farming. The farmer is the one to whom profit derived from farming accrues and therefore, he must stand the risk of loss. Funds also are needed for sickness, education, and other family uses. Saving must be accumulated by the successful farm family to provide a financial base for all such purposes.

2. Family arrangements
Family arrangements are of considerable importance in acquiring capital to farm, particularly for beginning farmers. Where parents or family members are able, gifts or loans are made to the beginning farm family to assist in providing capital. In other cases assistance in acquiring capital to farm is provided through formalized agreements, such as father-son partnerships, and rental arrangements.

Father-and-son agreements are the most common form of family arrangements. They provide a means whereby a son or son-in-law with limited capital can work into the farm business. From the father’s viewpoint such an arrangement often is desirable since he is able to “ease-up” a little bit. With the decrease in the amount of manual labor an older farmer can perform comes an almost certain decline in farm upkeep and income. The agreement also has advantages for the younger man, offering him an opportunity to start farming with less capital than is possible with any other method. By working with his father, he can profit from mature advice and can develop gradually his knowledge of agriculture and business and his management ability.

Various studies of father-and-son partnership agreements have shown that there are some factors that can influences successful of father and son farm partnerships:
a. Desire of the son to farm.
b. Satisfactory living conditions for two families.
c. Ability to get along with each other.
d. Belief that a farm partnership is desirable.
e. Adequate size of farm business.
f. Good farm management.
g. Good business judgment in the use of money.
h. Good partnership agreement.

3. Incorporation
Forming a corporation provides another method of acquiring capital to farm. A corporation is a legal entity authorized by state law and is capable of doing business, making contracts, borrowing money, and the like, the same as an individual proprietor. Individuals who form a corporation are its owners and are issued certificates representing shares to show the interest each holds in the corporate assets. The shareholders elect directors to represent them in business policy and management decisions. The directors in turn employ officers who operate the business according to policy established by the directors.

4. Leasing
Leasing – or renting – is a common way of obtaining additional capital for farming. Many leading farmers, who own considerable land, rent additional acreage to utilize more efficiently their managerial ability, and the land, machinery, and equipment they own.

Leases are usually classified according to the kind of rent paid. Most of them fall into three general groups: the crop-share lease, the livestock-share lease, and the cash lease. With share leases, a share of the crop or livestock production is paid in cash. The various types of leases may be combined or otherwise modified in renting a farm. A common method is to give a share of the grain crops as rent, and pay cash for pasture.

With the crop-share lease, the landlord usually provides the land and improvements and pays related taxes and other expenses, while the tenant pays most of the operating expenses and furnishes power, machinery and labor. Some expenses such as seed and fertilizer may be shared with the landlord. Crops produced are shared as agreed upon in the lease.

With cash leasing arrangements, the landlord is paid a specified cash payment and usually furnishes the land, buildings, and other improvements. The tenant furnishes all other items required for production, including labor, machinery, and operating expenses. The entire production of crops and livestock belongs to the tenant.

5. Vertical integration
Vertical integration means bringing together under central management two or more of the links in the chain of production and marketing. A farmer whose operations are vertically integrated shares with one or more related businesses – such as his supplier, processor, or distributor – some of his managerial decisions in production and marketing. A farmer whose operations are vertically integrated shares with one or more related businesses – such as his supplier, processor, or distributor – some of his managerial decisions in production and marketing. In return, the supplier, processor or distributor involved (the integrator) provides financing and assumes the associated risks. This linking together of two or more stages of the production – marketing process often is accomplished through contractual arrangements. Thus, it is sometimes contract farming.

Farmer-businessman arrangements can vary from connections only closer than conventional open-market relationships to full ownership and management of the farm by the associated business. However, the degree of vertical integration thus far in agriculture generally falls between these extremes, but usually involves varying degrees of financing the enterprise or operation. Therefore, vertical integration is another way for a farmer to obtain capital with which to work.

Advantages and Disadvantages of obtaining Capital Through Integration Contracts.

Advantages:
a) The integrator (businessman) assists with, or carries full responsibility for, management of the enterprise covered in the contract. Specialized management, with full information on latest scientific developments in feeding and other practices, probably facilitates more efficient production.
b) Risks are shared with, or completely transferred to, the integrator. While shifting risks does not remove them, it makes them more manageable by consolidation in the hands of the integrator.
c) With more capital, the size of the enterprise can be increased, contributing to greater efficiency in use of labor and equipment.
d) Specialized management and the larger amount of capital facilitates “continuous” production, - as with broilers where four batches may be produced each year, - thereby making more efficient use of buildings, equipment, capital, labor, and management employed in the enterprise.
e) With a larger enterprise, better breeding stock and seed varieties may be used. These, coupled with market demands, result in orderly marketing of a higher quality product that suits the need of the public.
f) With a large volume of business, the integrator is in position to use highly specialized equipment in production or processing which would not be possible for the individual farmer.
g) Greater efficiency in use of supplier-producer-processor resources and management, coupled with advantages such as higher quality products, contributes to an over-all net gain either in terms of higher income for parties involved in the production-marketing chain, or to a higher quality product at a lower cost for the public.
h) Judging from developments in industry, integration in agriculture might facilitate more orderly production and marketing of agricultural products. Real possibilities of gearing production to demand may be inherent in contracts between processors and farmers, or group of farmers.
i) Vertical integration probably has enlarged the number of farmers who can obtain financing. Some farmers unable to secure financing from other sources probably can obtain capital with which to work by means of contract.

Seldom if ever are advantages gained without a price, thus a number of disadvantages are also involved in integration, their importance, of course, depending upon the degree of integration provided by the contractual arrangements. Some of the disadvantages are:

i) With integration contracts which give full control to the integrator, the farmer gives up all of his freedom in making management decisions pertaining to the integrated enterprise. In such cases, he does not gain control of capital thus acquired, but merely has it to work with. With broiler-type contracts, for example, where the integrator retains title to the birds and provides operating capital, he has also makes the management decisions.
ii) The price a farmer pays for shifting some or all price and production risks and management to the integrator may be reflected in lower returns.
iii) Competition among suppliers has been a major stimulus to the rapid growth of vertical integration. Feed dealers, for example, use contracts as a method of increasing sales. Credit used as a sales tool may be overextended.
iv) Vertical integration may complicate farm business planning and related finances.
v) If contractual arrangements require the farmer to give highest priority to the vertically integrated enterprise, other enterprises may suffer and result in less net income than otherwise might be the case. In such event, credit to finance the nonintegrated enterprises may be more difficult to secure.

6. Borrowing
Borrowing means the ability to command capital or services currently for a promise to repay at some future time. In terms of money, borrowing involves obtaining a certain amount of funds to be repaid as specified in the note. The word “credit” comes from the Latin word “credo” meaning “I believe”. Hence, credit is based upon confidence. When one borrows money, the loan is based upon confidence in the future solvency of the person and in his repaying the loan as per agreement. In this sense, credit means ability to command the capital of another in return for a promise to pay at some specified time in the future.

When funds are obtained by borrowing, interest is paid for use of the capital; while, with a lease, rent is paid for use of the capital. Both borrowing and renting involve employment of capital for a period of time. However, the use of credit permits greater flexibility than renting. Credit can be used to acquire any type of resource or service needed by the farmer, while renting usually is employed to acquire use of fewer types of resources, the most common being farm real estate.

Borrowing involves more risk of losing owned capital than does renting. With renting, the maximum payment which can be demanded is the share or cash rent; this is somewhat comparable with the interest payment on borrowed funds. With share rental arrangements, the payment is automatically cut in case of low production or prices. With borrowing, however, the payment generally includes in addition to a fixed interest charge, part or the entire principal borrowed. If the principal is lost, the borrower may have to liquidate some of his own capital to repay loan.

Risks of crop failure and low prices are chief reasons against borrowing. If the crop and the price for it are highly uncertain – for example when yield and price of vegetables decrease – the farmer has little assurance under usual loan terms that can meet his obligations when they come due. It is the crop failure or the low price period which causes the debt distress which farmers want to avoid.