The Business Confidence Maximizer™ Online Newsletter

Have you ever heard about someone who claims that his bank or a supplier told him that if he only did one item, they would then be able to provide him with a certain type of financing arrangement? Sure, we all have. Often, I hear people state that their bank was planning to loan them an additional $600,000 to buy 400 cows if only they could upgrade their facility to handle the extra cow load.

“If a lender is unwilling to provide you with a written commitment letter, you most likely have the answer to your loan request. Obviously, it is not the one you were looking for, but it is an answer nonetheless!”

For example, they might need to improve their cooling system, add free stalls, or build more corrals, depending on the local climate. Since the industry is doing so well (e.g. in 2007-2008), why not make those improvements out of cash flow? The lender suggests that the dairyman should use his own cash to avoid becoming over-leveraged financially. Then, they contend, the borrower will be able to tap the equity of his herd to acquire loan funds for buying more cows.

BEWARE! I would not conclude that this is ever done intentionally, but it clearly can become a trap. Why? This is simply because the number one challenge for growing companies, whether they are dairies or high tech firms, is that they run out of cash just when they need it the most. The following true story tells just how this can happen…

Case Example

Ed called to say that his bank had “double-crossed” him. After asking for some clarification, I suggested that he slow down and tell me exactly what had happened. He said that, after a tough year in 2006, he felt a real need to expand his operation. This was likely true, given that it would allow him to spread his fixed costs over a greater number of hundredweights (cwt). However, this would not be possible without some extensive capital expenditures at his facility.

Here is where the real problems began. His loan officer suggested that if Ed could pay for these facility improvements (extra corrals and an improved milk cooling system) out of cash flow in 2008, the bank could then loan him money to buy additional cows. Overall, it sounds like a great plan, but here is how it “hit the wall…” First, he did not have a great deal of equity in his herd after the low milk prices of 2006. Just like many other producers, Ed had been forced to borrow money against his cows to maintain his cash flows with $10 milk.

After spending over $100,000 on his facility, he had no cash on hand to offset another round of low milk prices in 2009. In order to acquire the cows he needed to make this plan work, Ed would be forced to borrow 100% of the necessary funds to buy cows or heifers. Guess what? After the industry took another downturn in late 2008, nobody (including Ed’s current lender) wanted to loan him the money he needed to buy cows to complete his expansion plan.

Immediately, Ed had a problem! His cash flow was already suffering from the low milk prices. This problem was compounded by his having to buy cows at 100% loan to value. Remember, he had already spent his cash on the facility improvements. Finally, he was able to buy some high priced cows by using some outside financing. When I first met with Ed, I suggested that he was heading for a train wreck because of the high prices paid for the new cows, his high loan to value on his herd financing and potentially weak cash flows due to low milk prices throughout 2009.
What could he have done differently?

What If???

Suppose that Ed had requested a written commitment from his loan officer and even entertained the possibility of talking to a second lender. This process would have accomplished several tasks. First, his loan officer would likely have requested that Ed draw out his financial plan for the expansion. Additionally, the loan officer would have then reviewed Ed’s plan and hopefully made some suggestions to improve it wherever possible.

While it is true that a written commitment letter from the bank(s) represents a binding agreement on the part of the bank to take the expansion process to completion, it also accomplishes several other significant tasks:

  1. Before the bank will issue such a commitment to lend, they will require that the borrower develop, hopefully with the assistance of his CPA or Financial Advisor, a written Cash Flow projection.
  2. This Cash Flow projection should also be accompanied by a written plan that states why the project is being proposed, what its Cash Sources & Uses are, and when various steps of the expansion are expected to be completed.
  3. Most importantly, this process will answer the most important question looming out on the horizon.  Does it make sense financially?  If the answer is “Yes,” then go forward with it.  However, if the answer is “No,” then we can pursue what might represent better options.  For example, do we expand at a slower rate?  Should we buy younger, less expensive heifers and breed them ourselves instead of buying ones that are ready to calve within 30 days?
  4. In summary, this entire process will, once again, force Ed to “plan his work & work his plan.”  This always pays huge dividends!

Summary & Financial Tips for Success

  • I don’t know if promises were actually made by Ed’s bank, although I suspect that they were at least inferred.  This often happens, especially in good times for the dairy industry.  Unfortunately, the times of high milk prices are often followed by periods of depressed prices.  This is precisely why we need to develop an operating plan that can keep us on track, both from an operational standpoint and in knowing what our cash “sources & uses” will be.
  • In the prior story, there were numerous claims that it was all about “timing.” However, I would suggest that it is more than just that.  Historically, milk prices have always gone up and down.  As we face these highs and lows, we need to consistently ask ourselves, “Does this business plan still make sense?  Is it still profitable?”
  • Finally, any proposed financing should be accompanied by a written Commitment Letter.  This will clearly spell out the terms of the loans and credit lines being offered, i.e. there will be no surprises!  It is called a commitment letter because it literally represents a pledge by the bank to lend certain funds under specific conditions.  Most important, this document requires the signature of both the lender and the borrower.
  • One last point: If a lender is unwilling to provide you with a written commitment letter, you most likely have the answer to your loan request.  Obviously, it is not the one you were looking for, but it is an answer nonetheless!

Management Team Meetings Agenda

*** Leading Edge Topics to keep you and your Team at the Top of your Game!! ***

  1. Discuss with your Management Team whether it makes sense for you to expand your operation.
  2. What are the implications for your operation in terms of Fixed Costs, Variable Costs and overall stress on your current management regime and personnel?
  3. Is your lender on board for this change? This is important!
  4. Is your family on board for this change? This is crucial! You can find another lender, but, for most of us, finding another Family would have all sorts of negative implications…

Monthly Reminders – W.I.N.
(What’s Important Now?)

  • As you discuss whether or not to move forward with plans for expansion or other capital expenditures, think it through and be certain to develop a written plan.
  • Talk to banker(s) who might be able to assist you with the financing.  During these conversations, keep your ears open for possible solutions.  Even when you get turned down, a loan officer will sometimes make a great suggestion about how to better structure your deal.  If he cannot provide the necessary financing, he still might know of another source that can.
  • Be sure to develop a business plan or model that includes the projected cash flows for your operation.
  • After you’ve completed the three steps above, seek the financing options that look the best to you.  However, get any commitment from a lender in writing.  It can save a lot of misunderstandings later.
    Finally, now that you’ve planned your work, go forward and work your plan!

Looking Ahead

“Reduce your plan to writing… The moment you complete this, you will have definitely given concrete form to the intangible desire.”
– Napoleon Hill

In our next issue, we’ll take a look at what to do when you cannot find money for expansion or other improvements.  While banks normally come to mind for most of us, there are other sources.  Some of these can be internally generated, even in a year like 2009…

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