What is agricultural finance? Some, for example, may define agricultural finance as the study of the financing and liquidity services credit provides to farm borrowers. Others may define agricultural finance as the study of those financial intermediaries who provide loan funds to agriculture, and the financial markets in which these intermediaries obtain their funds. In fact, several agricultural economists identified a number of studies focusing on such additional topics as rural banking, insurance, income distribution, farm financial management, and taxation. Finally, the study of agricultural finance can be broaden even further to account for all economic and financial interfaces between agriculture and the rest of the macroeconomics, including the effects that changes in national economic policies have upon the economic performance of agriculture and the financial position of farm operator families.
Understanding financial concepts and the practical applications of finance is essential for anyone interested in pursuing a career in the agribusiness or agricultural production sectors. Many of the important managerial problems in agriculture involve finance. However, most agricultural production firms are significantly different from corporations, and more closely resemble small, owner-operated businesses. Management of farm business requires a wide range of information on physical and financial performance. Sometimes, however, much of the information needed is recorded only in the mind of the farm operator or in an informal, irregular kept ledger. There is also the tendency by some to judge the financial performance of a farm business by the amount of money he has in the bank. Each of these measures, however, provides a potentially misleading picture of the financial performance of the farm business and the financial strength of the farm operator. Study on Agricultural Finance will cover topics on the financial institutions, lending programs and other financial issues affecting agriculture.
Farm Financial Management
The functions of financial management are traditionally defined to include the investment decision, financing decision, and the dividend decision. Together, these decisions largely determine the rate at which the farm business grows over time. Because most farm business is sole proprietorships, financial management in agriculture encompasses the proprietor withdrawal decision (i.e. the withdrawal of funds to finance personal consumption and nonfarm investments) instead of the dividend decision.
The investment, financing, and proprietor withdrawal decisions are not made independently. For example, the decision to invest in a new piece of farm equipment cannot be made independently of the financing or withdrawal decisions. Furthermore, the financing decision is directly influenced by the farm operator’s decision to withdraw part of his current net farm income to finance personal consumption and nonfarm investment.
Effective investment, financing, and withdrawal decision making requires a comprehensive farm financial accounting system. For example, an accounting system is needed to help identify the level and timing of financing needed to facilitate the farm operator’s current production and marketing plans. Such an accounting system should also provide information pertaining to the farm operator’s present financial position and the efficiency and profitability of his current operations.
Financial Accounting System
An accurate and comprehensive set of financial statements is essential to sound financial management. Such an accounting system should at a minimum include a balance sheet, an income statement, a statement of change in owner equity, and a cash flow statement. These statements can provide an informational input to the production, marketing, investment, and financing decisions that must be made annually by the farm operator. For example, the information contained in these statements can be used to evaluate the annual performance of the farm operator’s business. This could be done by comparing the profitability and efficiency ratios computed for his business in the current year with similar ratios he has achieved in previous periods or with other farm businesses having similar types of operations.
Organization and Growth of the Farm
To maximize the profits generated by the farm business in the current period, the operator must be able to identify the appropriate combination of products to produce and inputs to use. In the longer run, the farm operator must also be able to determine how large the farm should be and understand what factors determine how fast he can reach this size. Some of the externally imposed factors that can constrain the rate of growth of the farm are external credit rationing, taxes, and government regulations. The farm operator can also internally constrain the rate of growth of the firm by rationing his use of credit or by withdrawing a larger part of net farm income to finance personal consumption expenditures or non-farm investments.
Investment and Financing
The concept of the time value of money underlines much of investment theory. For example, the present value of the annual net cash flows generated by an investment over its economic life must be taken into account when choosing between alternative investment projects. Several capital budgeting methods frequently used in financial management will be discussed in Chapter 5.
The presence of business and financial risk must also be taken into account when evaluating alternative investment projects with differing level of risk. The farm operators’ risk-return preferences (i.e., whether they are averse to risk, indifferent toward risk, or prefer risk) can have an effect on the ranking and acceptance of alternative investment projects available to them. To reduce their exposure to risk, farms operators can adopt one of several different strategies. These strategies include product diversification, sequential marketing of farm output, insurance, and forward contracting using either futures market contracts or cash forward contracts.
There are several forms of legal documents that farm operators should be familiar with when borrowing or leasing. These contracts document the rights and obligations of the borrower and lender, or lessor and lessee. It is important that the borrower and lessee understand the performance expected of them as set forth in these contracts.
Lenders, on the other hand, are concerned with the security of loans to protect themselves in the event that the borrower defaults on a loan. In some cases, the lender will accept a cosigner of a note. In other cases, however, a security agreement documenting the property the lender has a security interest in is used. A security interest gives the lender rights to those assets the borrower has pledged as collateral. The lender is also concerned about the borrower receiving a clear title to the property being purchased, particularly in the case of real estate.
There also legal considerations unique to leasing. For example, a legally enforceable lease must contain the names of the parties involved, a description of the property, the time period involved, and the timing and form of compensation. Farm land is typically leased on a cash rent, crop-share, or livestock-share basis. Machinery, on the other hand, is leased either through an operating lease or a financial lease.
To maximize after tax profits, farm operators must have a working knowledge of tax laws and the options available to them. Gains or losses associated with the sale of specific types of assets and the effects of minimum tax and self-employment tax will be discussed. The differences in the tax laws as they apply to sole proprietorships, partnerships, or corporations are also identified.
Financial Intermediaries Serving Agriculture
The financial intermediaries serving agriculture provide an important service by channeling funds from savers to borrowers in the amounts necessary to finance production expenses and capital expenditures. The funds used by these financial intermediaries come from variety of sources. These funds are then made available to agriculture under a variety of terms.
It is important for students studying Agricultural Finance to study the regulatory environment that each of the financial intermediaries serving agriculture must operate in, where these lenders obtain their funds, and the terms of the loans they make. These institutions are divided into four groups for discussion purposes: commercial banks, Farm Credit System, government lenders, and other financial intermediaries. The changing relative importance of these institutions over time is examined as is the joint participation between several of these institutions sometimes employed to meet the loan demands of larger farm operators. Finally, the performance of these financial intermediaries will be evaluated in terms of the efficiency and equity of their lending activities.
Source: Penson, John B. and Lins, David A. (1980). Agricultural Finance. New Jersey: Prentice Hall.