Here’s How A Cattle Feeder’s Banker Assesses Risk

Doug Thiessen, senior manager of group risk management for the Royal Bank of Canada (RBC), opened eyes to the financial realities of the cattle feeding business at this year’s Western Canada Feedlot Management School.

Thiessen came into the world of finance in an unusual way, through his experience in the livestock industry. He’s no stranger to the feedlot industry, having been raised on the family’s feedlot south of Strathmore, Alta., and representing a feed company for more than seven years. His position with RBC is based out of Calgary. If you are farming anywhere from B. C. through Ontario, he or his team are likely the people your account manager is talking to about the deal.

Though the nuts and bolts differ from sector to sector, Thiessen says the main frame of the risk assessment is standard for all agricultural businesses seeking financing. All banks and lending institutions will have some type of protocol in place for assessing the risk on accounts. It comes down to whether you’re dealing with a cashfl ow lender, security lender or venture capital lender.

“It’s important to understand how your bank looks at risk, because this tells you what you should be doing to successfully finance your operation,” he explains. The risk assessment impacts how much credit you can access, and the price you will pay.

A cash-flow lender, such as RBC, gauges risk in terms of your ability to make a living and repay the debt. They’ll want to see your business plan and talk with you about how you operate your business. They’ll discuss cash flow and are concerned with the long-term sustainability of your operation, but they aren’t involved in the day-to-day management.

Security lenders are primarily concerned with the value of your assets and not as concerned about your ability to repay. It’s the “if you’ve got the dirt, you can’t get hurt” lending model more commonly used in the 70s and 80s that resulted in lenders owning significant amounts of land during the economic downturn.

In comparison, venture capital lenders want a return on their investment and may want to be involved in managing your business. They are willing to take on greater risk, but the cost of financing is generally higher than that of financing with cash-flow and security lenders.

How a cash-flow lender sees it

Banks have resources to keep on top of the state of the industry. They take into consideration national and international situations such as market access, trade agreements, currency, and cattle on feed. They also look at provincial and regional strengths and weaknesses, such as supporting infrastructure, government programs, regulations, and cattle and feed prices.

Then, it’s your turn. Your cash-flow lender wants to know and understand how you manage your business. “It’s about your production numbers and production management systems, your financial management and monitoring systems, and your succession planning and human resources. How you manage your business overall will account for 30 to 40 per cent of how RBC risk rates your business,” Thiessen explains.

This is where a lot of farms may be challenged, he adds. Many farms don’t have business plans, or have relied on accountants or consultants to prepare a plan and don’t fully understand the assumptions or implications to their businesses. Secondly, there are still a lot of producers who lack information systems and, therefore, go by industry averages and coffee shop numbers.

“The majority of farmers will tell us they have great cost of production, great gains, great feed conversion and the best grades and yields. The challenge is that while they are focused on production, they may lack the tools or records to actually determine these numbers,” Thiessen says. The bank wants to hear how you develop and implement the systems that you have in place to achieve high production. For example, do you have health protocols to control death loss? Do you have a reliable feeding system so you’re not burning out cattle?

The bank also wants to know about how you manage information to get

your numbers. What records are you keeping? Do you have a system to track numbers so you can pull them out when you need them? Do your systems tell you things like your cost of gain, weight-in, weight-out or shrinkage in your silage pit?

“You need to have meaningful inhouse numbers — don’t delude yourself, just to make yourself feel better,” Thiessen stresses. Oftentimes he finds that people who run into financial difficulty knew in their minds that things were worse than they appeared — they just didn’t want to write down the numbers.

Cash-flow lenders want to hear about your employees and whether there is someone to carry on if, for any reason, you can’t be there.

“If you’re feeding cattle because you want to work with cattle, be prepared to have someone else manage the business part of it,” Thiessen warns. If you’re feeding up to 3,000 head, you probably will be able to spend 95 per cent of your time with the cattle. If you’re feeding more than 8,000, you’ll spend 98 per cent of your time managing the business, meeting with marketers, bankers, feed reps and clients, and no time with the cattle.

Your risk management strategy

The terms and conditions of contracts, or lack of contracts, is a huge issue in the custom feeding business. Guaranteeing a cost of gain and locking in specifiweights and dates for removal have been major issues that have ended up with custom feeders paying their clients large sums of money, Thiessen says.

The most disturbing trend he sees is contracts that let the client pay when they sell the cattle. Stop and think about why your client needs you to finance feeding the cattle, he advises.

Also of concern to the bank is how you are protecting the risk if a bank forecloses on one producer in pen-sharing arrangements.

Billing is another major problem. Make a point of billing clients regularly, timely and accurately.

“By definition, custom feeding is a service,” Thiessen says. “You shouldn’t lose money doing it!”

If you want to own the cattle, the bank will want to understand why it makes sense for you to own them rather than custom feed. They’ll want to know about procurement — your access to buyers and volumes of cattle, your purchasing contract, your quality control for the type of feeders you buy, and whether you intend to own them through to finishing.

On the marketing end, the bank considers loans to feedlots that ship to one packer, or mainly to the U. S., to be riskier than loans to feedlots with more and nearby options. They’ll want to know whether you have signed delivery contracts and grid pricing, or if you’re selling by open bid.

“Due to all of the variables in today’s beef industry, you need to understand the strengths and weaknesses of the methods you are using to mitigate risk,” Thiessen stresses. If you have contracts with a packer, is there a clause voiding the contract if the border is disrupted? If you are using the futures markets you need to recognize that all delivery points are in the U. S. and if the border is disrupted, the futures may actually increase in the U. S. while your cash price is falling in Canada. There are good tools available for managing basis risk, he says, but they have limited impact unless you also work to manage currency swings. Every one cent on the dollar translates to one cent per hundredweight over which you have no control.

Thiessen adds that even without the BSE market disruptions, the industry would have still faced significant losses due to the rise in the Canadian dollar from 62 cents to 80 cents against the U. S. dollar from 2003 through 2005.

Financial analysis

The financial analysis accounts for 40 to 50 per cent of your risk rating. The key ratios for cash-flow lenders are working capital (for owned cattle) or current ratio (for custom feeders), the debt-to-tangible net worth ratio, and debt servicing or EBITDA (earnings before interest, taxes, depreciation and amortization).

Reasonable working capital per head to support long-term stability is a significant portion of your financial risk rating with RBC. Custom feeding is a service, therefore, the current ratio (current assets divided by current short-term liabilities) is more applicable than a fixed working capital number.

Working capital and current ratio are indicators of your liquidity. Out of necessity to meet payments, a feedlot with low working capital or a low current ratio becomes reactionary, leaving little room to actually manage day-today business and less ability to move in and out of the feeding sector. Greater liquidity will allow you to manage your operation and react to buying opportunities fairly easily.

The debt-to-tangible net worth ratio (liabilities divided by assets) reflects the amount of debt you have owing on the estimated fair-market value of your tangible assets. A sufficient ratio will ensure that, whether you own cattle or custom feed cattle, you have the ability to access additional funding to respond to challenges and market opportunities.

Debt servicing is your ability to meet the loan payment from your operation’s available cash flow. The ratio (EBITDA divided by debt payments) will indicate your ability to take on new debt, manage unexpected expenses and handle profit fluctuations. For custom and owned cattle, RBC wants to see a three-year average that is positive and provides room to deal with volatility in the industry.

Thiessen adds that your loan payments are a fixed cost, which can be a competitive advantage or disadvantage for your operation. For example, if you have a 10,000-head feedlot and have principle and interest payments of $300,000 per year, your fixed financing cost is $30 per head space. A competitor that needs to pay $500,000 per year for the same size feedlot has a $50 per head space cost.

Security is considered in a cash-flow lender’s financial analysis, but only as a second way out, Thiessen says. It’s viewed as being detrimental to you, because selling off assets to repay loans may make it impossible for you to carry on. It’s also negative from a bank’s perspective because there is a risk of loss due to the decreased value of a forced sale and there is a negative impact to the bank’s reputation in the area.

“All business owners should have a plan in place that outlines where they want to go with their businesses and how they will get there,” Thiessen concludes. “Planning puts you in control, lets you identify and address potential risk factors before they develop, and ensures that you make sound management decisions. Our goal is to be there to help people with their unique needs, no matter what stage of development they’re at — start up, growth or succession.”

About the author



Stories from our other publications