and Capital the Use of Credit (Chpt. 19) Defns.: CAPITAL - DOLLAR AMOUNT INVESTED OR TIED UP IN BUSINESS ASSETS CREDIT - ABILITY OR CAPACITY TO BORROW MONEY Sources of Capital 1. Owner=s equity - largest source of farm capital A. Family (Inheritance) B. Savings/ retained earnings Farmers have a lot of forced savings. They will save for a down payment, and then make loan payments that exceed depreciation, thereby accumulating equity. 2. Outside Equity - investors 3. Leasing of Land and equipment A. Capital substitute that preserves borrowing capacity 2. Leasing is also a method of leveraging available capital by gaining short-term control of capital assets. 4. Contracting - custom finishing of swine, poultry contracting 5. Credit - second largest source of capital Borrowing capacity is an important business asset. Must be treated as an asset - preserved, some should be held in reserve for unforseen needs (personal and business).
WHAT CAN MANAGER DO TO PROTECT HER BORROWING CAPACITY? - Keep some of your credit line in reserve (Don=t borrow unnecessarily). - Factors that affect credit worthiness (see. Chpt 17) Personal character Management ability Financial position and progress Repayment capacity (cash flow) Purpose of loan Collateral Ability to provide accounting information Types of loans Secured Unsecured or signature loan Farm income statements typically show a considerable amount of equity, not unusual to find a modest farm in which the owner has 500,000 - 1,000,000. Do these farmers live like millionaires? No, the equity has been built through foregone consumption, rather than the fast bucks that accrue to farming no BMW's or Carribean vacations for most farmers.
LEVERAGE - Use of Borrowed Capital to Supplement and Extend the Use of Equity Capital Use of borrowed capital can increase business profit thereby boost the return to equity capital. If you employ your capital at less than you borrow it, you make money on the borrowed funds. If you invest your borrowed funds at less than your borrowing rate you lose money on those borrowed funds. How can a farmer tell if she is earning more on her borrowed funds than they are costing her? Are earnings greater than cost of funds? -Rate of return to capital - The size of your losses or gains on borrowed money are directly related to the amount borrowed. How do we measure the size of borrowings? D/E ratio - relative measure of borrowing The debt/equity ratio and the rate of return on capital determine how much money you gain or lose. LEVERAGE ALLOWS YOU TO INCREASE YOUR RETURN TO EQUITY Corollary: LEVERAGE IS A DOUBLE EDGED SWORD- LEVERAGE INCREASES gains IF CAPITAL IS EARNING ADEQUATE RETURN IN THE BUSINESS INCREASES losses IF CAPITAL IS not EARNING ADEQUATE RETURN IN THE BUSINESS
How do banks make money? Leverage and NFI: KEY IS THAT THE RATE OF RETURN TO CAPITAL MUST BE GREATER THAN THE COST OF CAPITAL (INTEREST RATE) TO INCREASE FARM PROFIT BY LEVERAGE. LEVERAGE and OWNER's Equity loosely speaking: RtC< i implies that return of owner' capital goes to cover losses on borrowed capital RtC>i implies that farmer is making money on borrowed capital The magnitude of the and leverage the overall rate of return to capital determine whether the NFI is sufficient to cover the interest expense. If RtC< Interest rate business will cannibalize Net Worth WHEN LEVERAGE IS VERY HIGH OR THE RATE OF RETURN TO CAPITAL IS VERY LOW SO THAT A BUSINESS BEGINS CONSUMING ITS EQUITY TO PAY INTEREST EXPENSES. THIS IS WHAT YOUR TEXT REFERS TO AS "THE PRINCIPAL OF INCREASING RISK". THE HIGHER THE LEVERAGE, THE BIGGER THE EFFECT OF A LOW RETURN TO CAPITAL. FROM A BUSINESS STRATEGY STANDPOINT, LEVERAGE PRESENTS A CONTINUUM FROM AN AGGRESSIVE USE OF CAPITAL A HIGH LEVERAGE STRATEGY MAKES RAPID GROWTH POSSIBLE , but only when RtC is adequate
A CONSERVATIVE BUSINESS STRATEGY IS TO KEEP THE USE OF BORROWED CAPITAL LOW LOW LEVERAGE PROTECTS EXISTING EQUITY if leverage is low enough, you just need a positive RtC to avoid eroding NW ?WHAT WOULD YOU THINK OF A FARMER WHO WHEN HE WAS YOUNG WAS VERY AGGRESSIVE IN HIS USE OF LEVERAGE, BUT IN MIDDLE AGE SWITCHED TO A MORE CONSERVATIVE STRATEGY - DOES HE OR SHE APPEAR TO HAVE PSYCHOLOGICAL PROBLEM - MAYBE SOME TYPE OF SPLIT PERSONALITY? -Willing to gamble that can earn adequate RtC NO IT IS THAT A SMALL BUSINESS HAS LESS TO LOSE AND A GREATER NEED FOR OUTSIDE CAPITAL TO SUPPLEMENT ITS MEAGER EQUITY.
THE RETURN TO CAPITAL TENDS TO BE LOW FOR FARM BUSINESSES, SO BORROWED CAPITAL MUST BE USED WITH CAUTION. The average return on Alabama farms is probably in the 4-8 percent range, although the range is extremely broad here. REMEMBER: Total ret. to cap. = NFI - opp. cost L&M - fam. lab. + interest expense. Assume Opp cost =0=fam. lab.
NFI= Ret. cap - interest expense % Ret. Cap. = Ret cap / (Debt+equity)
Effect of leverage and rate of return on net farm income example: Conclusion Leverage is a double edged sword: If return to capital exceeds interest rate on borrowed money, leverage will incerease NFI. If r...