Farm debt – good or bad?

A well-known story has a farmer asking his son how things are going after the latter has been farming on his own for a number of years. The son says it’s going well, as he already owes the bank more than R1 million. On the other hand, economists frequently warn farmers to use the higher income in good years to decrease their debt. Needless to say, there’s a lot of confusion about the role of borrowed funds in agriculture. Any business that uses borrowed money will be affected by the leverage effect, either positively or negatively.

Consider the case of Farmers A and B, whose farms are both worth R5 million. Each owes R2 million (40% debt), and their annual capital and interest repayments are R274 000. The difference between the two is that Farmer A had an income before tax, interest and capital repayments and personal living expenses of R600 000, while Farmer B’s was R225 000.

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Both spend R20 000 a month on household living expenses. After their capital and debt repayment of R275 000 and R240 000 living expenses, Farmer A has a cash surplus of R85 000, while Farmer B has a cash shortage of R265 000. The leverage effect means Farmer A is ‘creating’ wealth, while Farmer B is ‘destroying’ wealth. Thus the amount you can borrow should depend on the profitability (net income) of your business. As long as your percentage return on assets is higher than your cost of capital, you’ll increase income by borrowing money to invest in your farming operation.

Good and bad
A farmer without debt will only earn capital growth on his own funds. A farmer with borrowed money will earn capital growth on his own and on the lender’s funds. As long as he can afford the annual capital and interest repayments, he will grow at a much faster rate than the farmer without any debt. Investing borrowed money in assets that either appreciate in value, or increase production will generally result in an increase in wealth for the farmer. But farmers frequently fail to use all the interest-free money they can get.

Supplier credit is usually provided on 30-day or 60-day terms. This source of interest-free credit should be utilised as far as possible. Ideally, loans shouldn’t be used for non-productive investment in vehicles, houses and luxury goods. Uncontrolled borrowing to finance a farmer’s lifestyle through very expensive retail credit can soon result in big problems.

Bear in mind too that farming is a risky business. Input and product prices behave erratically over time. Yields are invariably more affected by climatic conditions than the farmer’s actions. Many farmers still remember the bad days when interest rates increased to more than 20%. All these factors create uncertain and fluctuating income and can result in big financial problems for farmers.

External finance
Conservative, but not over-pessimistic, capital budgets are therefore needed to support investment decisions.While it’s good to play it reasonably safe, it’s also true that, at some time, most successful farmers have taken a big risk and borrowed more than the calculations showed that they should. In most cases this resulted in fast growth and higher income. Farm income is just too low to enable a farmer to grow their business solely with own funds.

External finance provides the capital needed to increase the size and productivity of a farm. As long as the farm is a well run, profitable enterprise, borrowing money, especially at current relatively low interest rates, is a wise decision. Please note this article should not be regarded as constituting concrete financial advice. Farmers should consult their own financial advisors before seeking a loan.

Dr Koos Coetzee is an agricultural economist at the MPO. All opinions expressed are his own and don’t reflect MPO policy.

Contact Dr Coetzee at [email protected] with ‘Global farming’ in the subject line.