Farm credit appraisal techniques and farm financial analysis through financial statements

Presented by :Sondarva yagnesh MRoll no :105Reg .no : J1-O660-2011

Definition Agricultural credit : agriculture credit is the amount

of investment funds made available for agriculture production from resources outside the sector.

Farm finance : the amount of funds obtained from off farm sources for use on the farm ,repayable in future with an interest agreed to either explicitly or implicitly

Need of agricultural finnance Allocating larger proportion of land they own for the

cultivation of food crops for subsistence.

Predominance of family labour utilization in production of farm enterprise .

risk aversion

more demand for consumption credit

inability to offer security due to small size of holdings

Importance of agriculture finance

Increase in agricultural production is possible only by intensification and diversification of farming. Intensive agriculture needs huge capita

Farmers economic condition is subject to frequent climatic condition , therefore, either the continuance of cultivation of crops or making improvements on the farms depends on the nature and availability finance

Classification of credit

Based on purpose Based on time Based on security Based on liquidity Based on activity orientation Based on approach Based on contact with farmers

Based on purpose

Production loan

Investment loan Marketing loan

Consumptin loan

Based on time

1. Short term

2. Medium term

3. Long term

Based on security

1. Secured loans 2. Personal security 3. Collateral security 4. Mortgage (a) simple mortgage (B)equitable mortgage 5. Hypothecation (a) key loan (B) open loan

Based on liquidity 1. Self liquidating loan

2. Partially liquidating loan

Based on activity orientation

1. Sericulture loan

2 . Tractor loan

3. Orchard loan

Based on approach

1. Individual approach

2. Area approach

3. DIR loans

Based on contact with farmers

1. Direct loan

2. Indirect loan

Test of farm credit proposal

Three Rs of credit five Cs of credit Seven Ps of credit

Three Rs of credit

1. Return from the investment

2.Repayment capacity of borrower

3.Risk bearing ability of the borrower

Five Cs of credit

1. Character

2.Capacity

3.Capital

4.Condition

5.Commonsense

Seven Ps of credit

Principle of productive purpose Principle of personality Principle of productivity Principle of phased disbursement Principle of proper utilization Principle of payment Principle of protection

Procedural formalities in sanction of farm loans

1. Interview with farmer 2. Submission of loan application by farmer 3. Visit to the farmers field before sanction of loan 4. Criteria for loan eligibility 5. Sanction of loan 6. Submission of requisite documents 7. Disbursement of loan 8. Post credit follow up measures 9. Recovery of loan

Farm credit appraisal techniques

Introduction :The recommended analytical methods for appraisal are generally discounted cash flow techniques which take into account the time value of money. People generally prefer to receive benefits as early as possible while paying costs as late as possible. Costs and benefits occur at different points in the life of the project so the valuation of costs and benefits must take into account the time at which they occur. This concept of time preference is fundamental to proper appraisal and so it is necessary to calculate the present values of all costs and benefits

An understanding of discounting and Net Present Value (NPV) calculations is fundamental to proper appraisal of projects and programmes. A good understanding of Cost Benefit Analysis (CBA), Internal Rate of Return (IRR), Multi Criteria Analysis (MCA) and Cost Effectiveness Analysis (CEA) is also essential for economic appraisal purposes.

1 . Net Present Value (NPV)

In the NPV method, the revenues and costs of a project are estimated and then are discounted and compared with the initial investment. The preferred option is that with the highest positive net present value. Projects with negative NPV values should be rejected because the present value of the stream of benefits is insufficient to recover the cost of the project.

Compared to other investment appraisal techniques such as the Internal Rate of Return (IRR) and the discounted payback period, the NPV is viewed as the most reliable technique to support investment appraisal decisions.

Using different evaluation techniques for the same basic data may yield conflicting conclusions. In choosing between options A and B, the NPV method may suggest that option A is preferable, while the IRR method may suggest that option B is preferable. However in such cases, the results indicated by the NPV method are more reliable. The NPV method should be always be used where money values over time need to be appraised. Nevertheless, the other techniques also yield useful additional information and may be worth using.The key determinants of the NPV calculation are the appraisal horizon, the discount rate and the accuracy of estimates for costs and benefits.

The NPW of the project can be estimated using formula as given below

Bn = Benefits in n'th Year. Cn = Costs in n'th Year. n = life span of the project i = interest or discount rate

2. Benefit-Cost Ratio (BCR ) The BCR is the discounted net revenues divided by the

initial investment. The preferred option is that with the ratio greatest in excess of 1. In any event, a project with a benefit cost ratio of less than one should generally not proceed. The advantage of this method is its simplicity.

Using the BCR to rank projects can lead to sub optimal decisions as a project with a slightly higher BCR ratio will be selected over a project with a lower BCR even though the latter project has the capacity to generate much greater economic benefits because it has a higher NPV value and involves greater scale.

The BCR can be calculated using the following formula

Example: A fish culturist has invested and got Net benefit at the end of 1 ,2,3,4 year of fish culture in the following way:

Year Investment (Rs.)

Net benefit Discountfactor(12%)

Present valueinvestment

Present valueof Net benefit

0 40000 - 1.000 40000 -

1 2000 15000 0.893 1786 13395

2 3000 20000 0.797 2391 15940

3 4000 19000 0.712 2848 135288

4 1000 16000 0.63 636 10176

Total 50000 70000 47661 53039

NPV = Present value of Net benefit - present value of investment= 53,039 - 47.661 = 5378 (+) ve

BCR or PI = Present value of Net benefit / Present value of investment53,039 / 47,661 = 1.11 (more than 1)

3. Internal Rate of Return (IRR)

The IRR is the discount rate which, when applied to net revenues of a project sets them equal to the initial investment. The preferred option is that with the IRR greatest in excess of a specified rate of return. An IRR of 10% means that with a discount rate of 10%, the project breaks even. The IRR approach is usually associated with a hurdle cost of capital/discount rate, against which the IRR is compared. The hurdle rate corresponds to the opportunity cost of capital. In the case of public projects, the hurdle rate is the TDR. If the IRR exceeds the hurdle rate, the project is accepted.

There are disadvantages associated with the Internal Rate of Return (IRR) as a performance indicator. It is not suitable for the ranking of competing projects. It is possible for two projects to have the same IRR but have different Net Present Value (NPV) values due to differences in the timing of costs and benefits. In addition, applying different appraisal techniques to the same basic data may yield contradictory conclusions.

Payback and Discounted payback

The payback period is commonly used as an investment appraisal technique in the private sector and measures the length of time that it takes to recover the initial investment. However this method presents obvious drawbacks which prevent the ranking of projects. The method takes no account of the time value of money and neither does it take account of the earnings after the initial investment is recouped. For example, a project requires a €3 million investment and Option 1 returns €2 million in the first year and Option 2 returns €3 million for the same year..

On this basis Option 2 is the preferred option as the payback period is shorter but if the cash flows changed in subsequent years and Option 1 returned €2 million annually while Option 2 only earned €1 million annually, the chosen option would have been incorrect. The ordinary payback period should not be used as an appraisal technique for public investment projects

Sensitivity analysis

An important feature of a comprehensive CBA is the inclusion of a risk assessment. The use of sensitivity analysis allows users of the CBA methodology to challenge the robustness of the results to changes in the assumptions made (i.e. discount rate, time horizon, estimated value of costs and benefits, etc.). In doing so, it is possible to identify those parameters and assumptions to which the outcome of the analysis is most sensitive and therefore, allows the user to determine which assumptions and parameters may need to be re-examined and clarified.

Sensitivity analysis is the process of establishing the outcomes of the cost benefit analysis which is sensitive to the assumed values used in the analysis. This form of analysis should also be part of the appraisal for large projects. If an option is very sensitive to variations in a particular variable (e.g. passenger demand), then it should probably not be undertaken. If the relative merits of options change with the assumed values of variables, those values should be examined to see whether they can be made more reliable. It can be useful to attach probabilities to a range of values to help pick the best option.

Distributional Analysis The calculation of NPV’s makes no allowance for the distribution of

costs and benefits among members of society. This is an important drawback if the intended objectives of a programme/project aimed at specific income groups. Differential impact may arise because of income, gender, age, geographical location or disability and any distributional effects should be explicit and quantified where appropriate. A common approach to take account of distributional issues is to divide the relevant population into different income groups and analyze the impact of the programme/project on these groups. Weights can be attached to the different groups to reflect Government policy. Carrying out a distributional analysis can be a difficult task because costs and benefits are redistributed in unintended ways.

Economic appraisal techniques

1. Cost effectiveness analysis (CEA)

2. Cost utility analysis (cua)

3. Multi criteria analysis (mca)

Cost Effectiveness Analysis (CEA)

It is difficult to measure the value to society of public investment in social infra structure because the outputs may be difficult to specify accurately and to quantify, and are not frequently marketed. In cases like these, the cost of the various alternative options should be first determined in monetary terms. A choice can then be made as to which of the options (if they all achieve the same effects) is preferable. CEA is not a basis for deciding whether or not a project should be undertaken. Rather, it is concerned with the relative costs of the various options available for achieving a particular objective. CEA will assist in the determination of the least cost way of determining the capital project objective. A choice can then be made as to which of these options is preferable.

Cost Utility Analysis (CUA)

CUA is a variant of CEA that measures the relative effectiveness of alternative interventions in achieving two or more objectives. It is often used in health appraisals. In a CUA, costs are expressed in monetary terms and outcomes/ benefits are expressed in utility terms e.g. outcomes are often defined in quality adjusted life years (QALYs). This outcome measure is a combination of duration of life and health related quality of life. Whereas in a CBA, there is a requirement to attempt to place a monetary value on all benefits, CUA allows for a comparison of the benefits of health interventions without having to place a financial value on health states.

Multi Criteria Analysis (MCA)

Multi-criteria analysis (MCA) establishes preferences between project options by reference to an explicit set of criteria and objectives. These would normally reflect policy/programme objectives and project objectives and other considerations as appropriate, such as value for money, costs, social, environmental, equality, etc. MCA is often used as an alternative to appraisal techniques because it incorporates multiple criteria and does not focus solely on monetary values.

Tools of farm financial analysis

Balance sheet or net worth statement Income statement or loss statement Cash flow statement Break even analysis

Balance sheet

Balance sheet indicate an account of total asset and total liabilities of farm business revealing the financial solvency of business

Component are :

Assets Liabilities

Assets LiabilitiesNo. Items Rs. No. Items Rs.

Current Current 1. Bank Balance 30000 1 Operating loan payment 15000

2. Cash on hand 300 2 Forthcoming principal due on long term loan 3000

3 Accounts receivables 8004. Cocoon for sale 50005. Crops & supplies 3000

Total 39,100 Total 18000Intermediate Intermediate

6. Bullock pair 6000 3 Balance of sheep loan 70007. Milch Animal 30008. Oil engine 70009. Bullock cart 4000

Total 20000 Total 7000Long term Long term

10 Land, Dry land 10 Ac 80000 4 Mortgage of land 2500011. Garden land 3 Ac 6000012 Wet land 1/2 Ac 1500013 Mango garden 25000

Total 180000 Total 250005 Net Worth 189100

Total Assets 239100 Total liabilities 239000

Income statement

Summary of receipts and gains minus expenses and losses during a specified period of time.

Components :

Receipts Expenses

Particulars Amount (Rs.)

INCOME Cash Receipts

1 Paddy sales 30 qtl 75002 Sugarcane sales 16 tons 55003 Groundnut sales 20 qtl 120004 Milk sale 100 ltr. 38005 Broiler sale; 200 birds 105006 Miscellaneous income 1500

Total cash receipts 40800Net Capital gains Income

7 Sale of purchased milch animal 20008 Home bred animal sale 20009 Machinery sale 150

Total net capital gains 4150Changes in Inventory Value

10 Crops in inventory 600011 Livestock in inventory -100012 Total changes in inventory value 5000

Total farm income 49950

. EXPENSESOperating expenses

13 Hired labour 300014 Hired bullock labour 400015 Machinery, fuel, repairs 250016 Fertilizers 50017 Other crop expenses 140018 Livestock, machinery, veterinary and marketing

expenses1000

19 Interest on current debts 60020 Miscellaneous expenses 700

Total operating expenses 13700Fixed Expenses

21 Land rent 300022 Land revenue 50023 Improvement repairs 420024 Interest on intermediate and long term loans 1,00025 Equipment depreciation 150026 Livestock depreciation 100027 Attached farm servants wages 100028 Depreciation on buildings, improvements 600

Total fixed expenses 12800Total expenses 26500

Net farm income 23450

Ratio analysis

Ratio analysis will explain what strength, weakness, pressures and forces are currently at work in your business operation farm business managers will need a full time job accountant for the change accruing in his capital structure and net worth as revealed in his balance sheet. Ratio analysis of properly calculated rates can be readily compared with :I) firm’s past ratio in order to show trends, Ii) ratio of other firms of similar size, large size or of smaller size with which the manager is familiar, Iii) industrial standards and Iv) projected goals as reflected in plans for the future.

Ratio formula Best condition

Period of time

Indicate

Current ratio TCA/TCL >1 1 To meet immediate financial obligation

Intermediate ratio

TCA >1 2 to 5 To meet intermediate financial obligation

Net capital ratio

TA/TL >1 >5 Solvency position of farmer

Acid test ratio

Current asset /TCL

>1 2to 5 Adequacy of cash and income surplus to cover all current liabilities

Current liabilities ratio

Current liability /owners equity

<1 1 to 2 Immediate financial obligation against net worth

Debt equity ratio

Total debt/Owners equity

<1 >5 Capacity of farmer to long term commitment

Equity value ratio

Owners equity/Value of asset

<1 Productivity gained by farmer in relation to asset he has

Cash flow statement

Summary of cash inflows and cash out flows of a business organization in a particular period say season or year .

Component :

Cash receipts Cash expenses

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