PRINCIPLES OF CREDIT MANAGEMENT - 3R CONCEPT

The word “credit” comes from the Latin word “credo” which means “I believe”. Hence, credit is based upon belief, confidence, trust and faith. The loan is based upon the confidence of borrower’s future solvency and repayment. Hence, credit means ability to command the other’s capital in return for a promise to re-pay at some specified time in future. Besides, credit is the combination of “ability to borrow” and “willingness to borrow”. Infact, credit is an individual’s borrowing capacity, often being considered as an “economic good” to be produced, managed and marketed.

Returns from an investment: The first R of credit

The returns from an investment, the first test of credit, has great significance to both creditor and borrower. It requires that both borrower and lender are satisfied about the returns from credit which cover the principal and interest. Furthermore, the basic question pertaining to returns analysis is whether or not the use of credit generates adequate income and is most profitable use. Thus, even though the use of credit may be profitable it should also be examined whether or not it is the most profitable. Similarly, the examination of returns from an investment in terms of generating adequate incomes to compensate for the contribution of family labour and management as well as building owner’s equity is also essential. Hence, overall profitability of a farm business must be evaluated to assess the possibility of earning income from most profitable enterprise to compensate the loss from another.

Thus, the problem of determining the most profitable use of capital is a part of decision making and involves, (a) the selection of most profitable enterprises (product-product relationship), (b) determining the most economical production techniques(factor-factor relationship), and (c) determining the size of each enterprise (factor-product relationship).

However, the following points may be kept in mind while calculating the expected returns from the borrowed funds.

1 Estimate the gross returns by multiplying average yields with its corresponding expected average prices, the conservative prices should be used for safety purpose. These gross returns should be worked out both with and without borrowed funds.

2 Estimate the total cost both with and without borrowed funds, these costs should be slightly on higher side to take into account the risk.

3 Estimate the additional cost and additional returns from the investment, do not use average cost and average returns.

The use of credit becomes an economically sound proposition, if the net cash income is more due to the use of borrowed funds, with a sufficient margin for income variability.

Repayment capacity: The second R of credit

It should also be taken into consideration while extending/borrowing a loan. In fact, it is not only sufficient for a loan to be productive rather it should also generate adequate returns so that loan instalments can be repaid. It is quite possible that a loan may be productive but may not generate adequate income after meeting the family and farm expenses to regularly pay the loan instalments.

The repaying capacity is the amount of money that a farm family would be able to spare from their total earnings so as to repay the loan after meeting his farm and family expenses. Ability to repay a loan is influenced by the income generating capacity of the farm business, off farm earnings, the liquidity of the farm as reflected by the balance sheet and the cash flows on the farm (with due consideration for farm and family obligations). Furthermore, the ability to repay may be influenced by numerous factors but willingness to repay a loan is quite essential. In short run, the current assets must be able to repay the current liabilities.

However, in long run the sufficient income must also be available (after meeting operating expenses, family living expenses and expenses for the farm-firm growth) so that debt obligations can be repaid. In this contest, the cash flow analysis of a farm business depicts the complete picture of repayment ability, i.e., the period of cash inflows so that loan terms and payment dates can be tailored with it. For maximization of the net returns from an investment, the credit is to be used upto the point where additional (marginal) net income equals to that of additional (marginal) cost. Therefore, the repayment of principal and interest depends upon the type of loan taken by the farmers, viz., self-liquidating and non-liquidating or partially liquidating loans.

Self-liquidating loans:- These are loans to acquire goods or services that are completely used up in one production season or in annual production process. These are, infact, the short-term loan (operating expenses) which become a part of working expenses in the single production process. In estimating repaying capacity the borrowed funds are not deducted as costs are included in working expenses. The repaying capacity for such loans should be determined as below:

Repaying capacity = (Gross income including off-farm income) minus (living expenses + working expenses excluding proposed loan +taxes and L.I.C. premiums + other loans and repayments due).

Non-liquidating loans:- These are loans where resources acquired are not expended or consumed up in a single production process, i.e. the acquired resources are consumed over a number of years. Such loans do not completely become a part of the first year’s costs and returns from such investments are spread over a number of years. A loan for the purchase of tractor or land reclamation is an example of non-liquidating loan, i.e., all the medium and long term loans are non-liquidating loans. These loans may contribute indirectly to the repayment capacity by enabling the farmer to produce more net income than otherwise would be possible without the use of such resources. The repaying capacity for such loans is worked out as:

Repaying capacity = (Gross income including off farm income) minus (working expenses including seasonal loans + living expenses +taxes and LIC premiums + repayment of other loans due).

The poor debt-servicing capacity can be due to:

1 Small operational land with inadequate infrastructures on these farms ultimately result into the lower gross returns.

2 Lack of appropriate avenues for off-farm income in the area/region. 

3 Poor yield of crops due to factors such as poor land, inadequate/erratic rainfall, salinity/alkalinity problems, disease and pest infestations, low adoption of improved technology, etc. Similarly, rearing of low yielder milch animals, small herd size, lack of adequate feed and fodder, veterinary facilities, in-efficient milk marketing etc. may result lower returns from milch animals.

4 Sale of crop produce during the post harvest months (also through in-efficient channel), distress sales and poor market infrastructures.

5 High production costs due to high input prices (also due to in-efficient purchase of farm inputs).

6 Diversion of loans for unproductive purposes, and High cost of living.

Above listed, the first four factors reduce the gross returns while the last three factors

increase expenses. All these factors reduce the net cash income and there by ability to repay the loan or debt servicing capacity.

Risk bearing ability

Risk bearing ability, the third R of credit, determines the quantum of credit which can be safely used by the farm-firm. It means the ability of borrower to withstand the unexpected low incomes, unpredictable losses and expenses and to continue the farming. It provides the “last line of defence” in the use of credit. It is quite possible that a loan may be productive and may also generate adequate repaying capacity but borrower may not be able to afford the shocks of probable financial losses due to poor/inadequate risk-bearing ability. The assessment of risk bearing ability is, therefore, essential since both returns and repayment capacity are based on average estimates of production, prices and costs, which seldom hold true. Farming is exposed to the many natural hazards such as, attack of insects, pests and diseases and also to the price fluctuations. Instability in farm income is more common as compared to the stable farm income. Consequently, most of the farmers are risk- averter rather than the risk preferer. Hence, the variability in gross incomes has to be accounted for before arriving at a fairly stable and also reliable estimates of the level of repayment capacity. The stable repayment capacity, based on deflated gross returns, may be worked out to account for risk-bearing ability of the borrower. For this purpose, the general variability coefficients of the area may be considered due to non-availability of these coefficients for an individual borrower in developing countries. From deflated gross income, deductions should be made for farm and family expenses and the loans due. The balance would indicate the repayment capacity for the relevant period.

Stable repayment capacity = (Deflated gross returns minus working expenses plus family living expenses plus old debt payments plus L.I.C. premium, etc.)

The stable income or financial position though determines the borrower’s ability to bear the financial shocks yet the risk bearing ability of a borrower depends upon the following factors:

1) Ability and willingness to save.

2) Ability to borrow, i.e., credit worthiness of the borrower as a person, especially in bad times.

3) Ability and willingness to adjust and withstand the adverse conditions, i.e., reducing both operating and living expenses in bad periods.

4) Equity and net worth, the backbone of risk bearing ability.The risk bearing ability can be enhanced by certain measures such as:

a) Taking crop, livestock and other insurances.

b) Adoption of financial strategies (e.g. internal cash or asset rationing, internal and external credit rationing and reducing farm and family expenses.)

c) Adoption of suitable marketing strategies (such as hedging, forward contracts for sale of farm products and purchase of input supplies to reduce price risk).

d) Adoption of suitable production strategies (such as flexible production programmes, use of plant protection, weedicides and other farm practices, growing less risky or more stable farm enterprises, diversification of farm production programmes).

e) Building up of owner’s equity or net worth through savings and personal credit through fair dealings.