Financial risk is the worry that lurks in the back of every business manager’s mind. Farmcare’s David Gardner examines ways to minimise the risks
Volatile market prices, investment in non-core farming enterprises and the need to maintain a sound exit route from the farm when circumstances dictate all conspire to push financial risk up the agenda for farm business managers.
But as the nature of financial risk has changed so has the ability to do something about it.
Today, it is easier to change sources of finance and financial advice – banks, finance houses and accountants – as you would any other key supplier. More businesses are constantly looking at debt and regularly challenging suppliers on terms and conditions. Consolidating debt from short to long term, moving assets around and investing on the basis of genuine return, not long-term tradition, is increasing in farming businesses.
There are new instruments of financial management and control available today, such as interest rate management. In the past 30 years, interest rates have varied between 3.5% and 17%, with an average base interest rate of 9.05%. Yet in the past six years it has stabilised between 4% and 6%. At the same time, Bank of England figures show that lending to farmers is at an all time high.
This suggests that agricultural businesses may be at high risk if interest rates take off again. For a premium, interest rate risk can be managed using various financial tools. The cost effectiveness of these tools needs to be assessed for individual circumstances. Exposure to interest rate moves and how sensitive the business is to interest rate changes are key measures.
For instance, even low gearing against static or falling income creates great sensitivity; heavier borrowing in a business, but with high cash flow, mitigates the risk.Calculating the business’s sensitivity to interest rates requires “what if” scenarios. The change in the interest cover ratio at different interest rates will give an indication of sensitivity.
The tools
1. Fixed rates
Opting to pay a fixed interest rate on borrowings makes budgeting and forecasting easy, but if variable interest rates move in your favour, you miss out on the potential gain. Fixed interest rates are at a premium to the variable interest rate.
2. Interest rate caps
An interest rate cap is used to guarantee the maximum rate of interest you pay while retaining the full ability to benefit from lower rates. For this expect to pay a premium, which will depend on the loan amount, the length of time for which the cap is required and the interest rate at which the cap is set.
3. Interest rate collars
An interest rate collar is used to guarantee the maximum rate of interest paid. But a collar also involves a limit to how low the interest rate can fall, just allowing rates to move within an upper and lower limit. In return for giving up some of the benefit from possible lower rates, the premium that would be paid for a cap is reduced.
This makes collars cheaper than caps while retaining some of a cap’s benefits. The premium paid will depend on the loan amount, the length of time for which the collar is required, and the level at which the floor and ceiling interest rates are set.
4. Interest rate swaps
An interest rate swap allows you to swap the variable interest rate of an existing loan for a fixed rate or vice-versa. Again, the rate will depend on the period of the swap, the method of calculating the interest rates to be paid, and if the swap is for a loan with a fixed or variable interest rate. When considering how to manage interest rate risk consider:
- Current position and future position of the business in relation to exposure and sensitivity to interest rate changes.
- Likely future direction of interest rate movement, although the flexible nature of the products available to manage interest rate risk makes this less important.
5. Role of insurance
Insurance is a more familiar financial risk management tool; in effect, used to transfer risks to a third party for a fee. There are an increasing number of policies which can be bought to partially or wholly protect the financial status of both the farm and family including coverage for personal and farm property, liability, crop health, livestock, life and long-term care.
6. Bad debt
Bad debt is a big financial risk to which many farmers seldom feel exposed. But when it hits it can hurt – badly.
Credit worthiness
Traditionally, farm produce is sold to large buyers or through markets where the seller does not even have to raise an invoice to get paid. The self-billing process ensures that payment will turn up in due course without any action being taken. On market days you can call at the auctioneer’s office before going home and pick up a cheque.
This is not typical of the wider business community. Most businesses would systematically review the credit worthiness of buyers and still have to put significant effort into chasing payments and will regularly write off some bad debt.
As more farmers move into diversified businesses they will have to develop processes to manage debt and should seek to spread risk by trading with a variety of merchants wherever possible.
Businesses should have a process for identifying ageing debt. A simple spreadsheet would usually suffice where overdue payments are listed.
The debt can progress across the spreadsheet as it ages from the 0-30 days overdue column into the 30-60 days. Eventually it will sit in the 90 days plus column.
As it progresses it should be chased with phone calls and letters before eventually passing it to a solicitor for legal action. Both new and established buyers should be given credit ratings and active decisions made about how much credit any business should have. There are a number of ways to assess credit risk:
- A formal credit rating from a credit rating agency, such as Dunn and Bradstreet (www.dnb.com) or The Humberside Trade Protection Association (www.htpa.demon.co.uk). Once an account is opened, a phone call and small fee will secure a credit rating. Some Trade Associations also monitor credit terms and debt profiles of the agricultural sector.
- Use your judgement based on how well you know the business and what proportion of sales go through that business. How catastrophic would a customer’s collapse be?
- Read the trade press and listen to rumours. Is the customer considered to be weak? If so, reduce exposure. Some sales offer the chance to avoid debt; eg, grain can be sold on “cash and carry” deals where 80% of the value is paid in advance. Only a limited part of the overall deal is ever exposed.
Recovering bad debt involves the courts. The small claims court can be used for sums up to £5000. For more information on the small claims court visit www.bbc.co.uk/crime/law/smallclaimscourt.shtml. Larger sums are pursued through the county court and will usually involve a solicitor.
PLEASE NOTE: The test yourself in this academy does not have right or wrong answers and are for guide purposes only.