What is the lender looking for?

How to take charge of the loan approval process.

The key to a successful outcome begins with first understanding what the lender is looking for when you apply for a loan.

One of the most important activities you may have during the year is meeting with your local lender.  It is also probably the one that causes you the most anxiety.  Whether the meeting is for general operating funds or to purchase capital assets (i.e. equipment, livestock, real estate), you want the lender to make an investment in the farm and approve your request.  The key to a successful outcome begins with first understanding what the lender is looking for when you apply for a loan.

Believe it or not, lenders don’t simply want to see the “right numbers” put in front of them.  What they really want to see is that you are taking charge of the loan approval process.  That may seem strange, since you’re the one asking for money and they have to say “yes.”  However, lenders recognize that you are the manager of the farm and know more about the business than they do.  They also realize that providing a loan impacts your business and they want to know how that impact will be beneficial to the success of your farm. 

Simply showing the “right numbers” doesn’t provide enough insight into the success of the business. That is why lenders often proceed with caution and look for assurances that approving your request is a good decision. 

To provide assurance, begin with understanding the parts of the loan process and what the lender wants to see. Most loan applications require a balance sheet, your recent IRS tax returns, production history, and a cash flow projection.

Balance Sheet

A balance sheet lists the value for all that you own (assets) and the amount of all that you owe (liabilities).  What is a lender looking for here?

It’s not simply a matter of putting values to your assets and showing that you own more than you owe.   The lender uses the balance sheet as a first look into your operation and first impression of you as a manager.  How much detail do you provide?  Are all the farm assets included?  Are assets valued using reasonable, realistic values? 

There are four main areas of concern with the last question: crop inventory, farm machinery, livestock, and real estate.

  • Crop inventory should be based on market values as of the date of the balance sheet. This helps identify if you have enough collateral (debt free assets) to secure the loan.  It also demonstrates your awareness of market conditions and their potential challenges.  Market awareness is crucial if you sell commodities or potentially have to purchase them for feed.   
  • Farm machinery is always worth more to you than it would be to a potential buyer. What matters to a lender is what you would realistically expect to receive in an actual sale.  To value your equipment, start by looking at farm auction listings and avoid sales advertisements.  Auction listings give you an idea of what buyers are actually paying for equipment similar to what you own.  Sales advertisements only provide what other people “think” their equipment is worth, but the final purchase value may be much lower.    
  • Livestock should be valued similarly to farm machinery using the same reasoning. This is especially true in cases of high market volatility where prices are known to fluctuate.  For much of the livestock industry, market volatility has been an ongoing problem for the past several years.  One place to look for livestock values is the USDA Agricultural Marketing Service that provides reports from various states across the country.  While a report for Michigan is often not provided, these market reports still provide you with an idea of what livestock are actually being sold for in your region.
  • Real estate is best valued based on appraisals, which compare sales of similar property within the previous year. However, appraisals can be costly and are generally done prior to a sale or purchase of real estate.  Another option is to use the State Equalized Value (SEV) and multiply by two.  This is the market value determined by the local assessor. While this value may be less than perceived market prices, it is a good starting point in the absence of actual sales data of similar properties.

IRS Tax Returns & Production History

Loan requests typically require a copy of your IRS tax returns and production history for the past three years.  What is a lender looking for here?

Lenders want to gain an understanding of the financial and production capabilities of your farm.  They use these documents to review your ability to turn production into revenue and pay expenses during that time period.  This review includes calculating an average for the past three years and identifying any trends.  Prior to applying for a loan request, you should identify the same average and trends that the lender will see and prepare yourself to talk about them.

If production or revenues are trending down or expenses trending up, what is causing the trend?  Being able to talk about your history demonstrates your understanding of what conditions the farm is operating within and what actions you have taken to change them.  It also provides an opportunity for you to discuss how you plan to continue working through them and how the loan will aid you in those efforts.

Cash Flow Projection

Loan requests typically include providing a cash flow projection.  What is a lender looking for here?

A cash flow projection is an opportunity to demonstrate your ability to make money and address risks or concerns to your business.  Lenders want to see a projection that is consistent with your farm’s historical production, revenue, and expenses, and also takes into account current market conditions. 

To ensure consistency to your history, be sure to start any projection using your farm records.  They were used to fill out your IRS tax returns, so they should be used when creating your projection.  Then consider any changes you are going to make for the coming year.  Are you anticipating lower costs to inputs than in the past?  Are production volumes (yields or livestock sold) expected to be higher?  Are you using prices consistent with what is available on the market?

These questions can all have an answer of “yes” and the reasons “why” can be acceptable to a lender.  The key is being able to explain why those differences exist and how they fit into the overall plan for your business.  A common example is introducing a new fertilizer program that increases yields at similar or reduced costs.  Another example is having a new livestock feeding program that lowers cost and increases rate of gain efficiencies. 

As you prepare to meet with your lender, remember that they want nothing more than to see you be successful.  They understand the importance of the request but also that there are risks involved in farming.  They consider your well-being and whether additional funding will truly be a help to your operation.  Knowing how to assure them that the loan will benefit your farm is what will put you in charge of the process.  Most importantly, it will increase the likelihood of a “yes” to your request.

Visit the Michigan State University Extension Farm Management website for information and resources on a wide variety of farming-related topics.

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