Investment and Borrowing on Dairy Farms
Some investments on dairy farms lead to additional profits/cash flows. Others tie up capital or, worse still, lead to reduced profits/cash flows into the future. Investments that potentially increase profits/cash flow include quota, stock and land. Investments that tie up capital are machinery and buildings. Dairy farmers must maximise investment in the former and minimise investment in the latter.
Should You Invest?
Sensible investment can be identified by calculating a rate of return. A simple rate of return for an investment can be defined as the additional profit pre interest as a percentage of the cost of that investment. For example the purchase of land and quota costing €100,000 which will increase farm profits pre interest by €5000 gives a simple rate of return of 5000/100,000 x 100 = 5%.
The rate of return on the investment can be compared with the cost of borrowings or the cost of own funds. This rate of return is before any potential gain in the value of assets purchased. Currently, I believe there is a limited potential for capital gain in the short and medium term for most asset classes.
This means investments must earn a sufficient rate of return in the short term through additional profits, to justify the investment. Some property developers currently work on a rate of return of around 7%. In the case of farm investments with a potential for long term capital growth, I suggest a return of 5% should be the minimum requirement but ideally we should be looking for 7% - 10%.
Borrowing capacity varies with quota size, level of efficiency and cost of living to be covered by the enterprise. In addition, leased quota will only have half or less the repayment capacity of owned quota.
Generally the long term borrowing capacity of quotas of 50,000 gallons will at most be €50,000, assuming little or no short term borrowing. The borrowing capacity of a 100,000 gallon quota could be as high as €200,000, again assuming little short term borrowings.
Guideline figures are of limited use to the individual farmer. Before large borrowings are taken out, the investment should be evaluated as to rate of return and a cash flow prepared to see if proposed repayments are feasible.
Structure of Borrowings
Most dairy farmers should finance investments, other than land, over a maximum of ten years, and over 15 years for land. As we are facing into tighter margins these terms give some leeway to restructure to a longer period if repayments cause too much hardship.
Some large operations operate on the basis of paying interest only on loans and leaving the capital balance constant. This also happens with pension backed loans though payments to a pension fund are effectively tax efficient capital repayments. The advantage of this approach is that much greater levels of borrowings can be carried for any given repayment capacity.
For example a repayment capacity of €20,000 in the first years of a loan will carry -
- a loan of €153,000 over 10 years at 5%
- a loan of €400,000 if interest only is paid.
In addition, as a term loan proceeds it becomes difficult to meet capital payments as there is no tax relief on such payments. With interest only type loans it is important that the return on the investment is greater than the cost of funds or that there is a definite potential for capital growth.
Interest Rate Options
Interest rates charged to an individual dairy farmer depend on repayment capacity, security and track record. They also depend on negotiations with your bank. Overdraft interest rates charged to dairy farmers typically vary from 6% to 10%. Similar variations exist with regard to term loans.
When borrowing, dairy farmers can opt for a rate on a term loan which will vary from time to time with quoted interest rates or they can link rates to the Dibor or Eurobor rate. The Dibor and Eurobor rates are the inter bank rates for cost of funds. Banks will charge a premium on these rates.
The inter-bank rate varies on a daily basis but will always be a keen rate on the day. Assuming a dairy farmer borrows at a 2% premium on a Eurobor rate of 3.1% he will pay 5.1% on his loan. The 3.1% rate will vary on a daily basis while the premium will remain constant.
Variable or Fixed Rates
Variable rates of interest are cheaper than fixed interest rates. However, a fixed interest rate means a dairy farmer knows his commitments into the future. Currently, a fixed rate will cost about 1.25% more than a variable rate for a period of five years. The extra cost of a fixed rate could be viewed as insurance against interest rate rise. Euro interest rates will probably fall a little further but are near the bottom of a cycle. Fixing interest rates before the cycle changes to an upward one would make sense but nobody knows when this will happen. Highly borrowed farmers might consider converting half their loans to a fixed interest rate to reduce risk.
Many dairy farmers traditionally use the overdraft to finance working capital i.e. capital required for approximately six months to cover input costs while awaiting sales. This made sense in the past when this was the cheapest source of credit. Nowadays, overdraft is the most expensive form of credit. Dairy farmers should work out what their working capital requirements are and use a seasonal loan (called various names in lending institutions) to cover requirements. Overdrafts should only be used for very short term requirements i.e. 1-2 months. Seasonal loans are typically 2.5% cheaper than overdrafts.