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September 12
Understanding Operating Loans

By: Martin Kasperski

Farming is a capital-intensive business, with land, equipment and facilities that can run into millions of dollars. Beyond these capital expenses, farmers face annual input costs for seed, fuel, chemicals, etc. These inputs are often needed at the beginning of the growing season and paid for with proceeds from the sale of crops months in the future. To bridge this gap, many farmers utilize an operating loan, which is a revolving line of credit for the farm.​

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These loans are tied to the production or operating cycle: money loaned at the beginning of the season is expected to be used for the essential inputs needed to raise that season’s crop, and then paid back at the end of the cycle with the proceeds from the crop or product that was produced using the inputs purchased. This is different from term loans as those are tied to the productive life of the asset being financed, such as up to seven years for equipment or up to 30 years for real estate loans.

Often, using operating funds provides producers access to early-season or pre-paid discounts. For example, reduced prices on seed if purchased in December for a crop that will not be planted until April. In the current economic environment, higher input costs, along with lower crop prices, have led to lower levels of working capital. As a result, operating loans have become more prevalent even among the most financially sound farmers who may have traditionally paid for inputs with available working capital.

Many farmers employ the revolving line of credit at the beginning of the production cycle, then pay it off at the end of the productive season using the profits from the sale of their crops or products, and then start the process again for the following season. Using an operating loan, money is drawn as needed and interest begins accruing only as funds are pulled from the credit line. 

Operating loans are not commonly used to finance capital investments, because of the short-term nature of the loan. Short-term financing for a long-term asset can cause repayment challenges, which is why farmers more commonly match their financing to the useful life of the asset. 

Typically, the security for operating loans is the chattel, a word used for shorter term farm collateral, which can include the crop, both growing and stored, as well as machinery and equipment. Occasionally, a farmer will prefer to use real estate as collateral for an operating loan, such as in scenarios when the crop itself is jointly owned, or there is a prior lien holder on the crop. Security for the operating loan is primarily the borrower’s decision based on their operation’s unique situation. However, when the crop is used as the collateral, in some cases the lender may also require crop insurance, with an assignment of indemnity on the policy. 

One of the risks of employing an operating loan is when the crop itself does not yield enough return to pay off the loan, such as when prices drop unexpectedly or poor yields. In this type of situation, the farmer may be forced to carry the operating losses into the following crop cycle if they do not have alternative capital available to cover the balance. As farmers know, the continuation of this situation impedes profitability and the accumulation of working capital, and increases financial risk.

Operating loans are common across industries, from dairies to cash crops, fruit orchards to vegetables, nurseries to greenhouses. When used properly, they provide financial liquidity when it is needed most, with a short-term repayment to be able to efficiently remove this debt from the balance sheet.​

Martin Kasperski is a senior financial services officer with GreenStone.
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