Understanding the true cost of capital:  Why cheaper capital isn’t always better

Making sound decisions on your farm is essential to healthy operations.  With expenses rising due to the increased production costs, many farmers have had to shift strategies around their working capital in response.  “Beware,” cautions Peter Martin, ag advisor at KCoe Isom, “because cheapest isn’t always best when it comes to the cost of your capital.”

Of course, you must consider the tangibles, like your interest rate. But there are also intangibles to think about, factors that can make a big difference in the cost of running your operation.

Capital can come from many sources: debt, equity, supplier financing, even friends and family. Some farmers operate with very high levels of debt, others with none. There is no perfect capital structure for all farms, only what works best for your business.

But “there are universal guidelines for evaluating your capital stack,” advises Martin. “And there are ways to improve your cost of capital over time.” Consider these factors to understand the true cost of your business capital:

  • Investigate your interest rate. It’s not only important to know the main cost of borrowing but the fees that go with it. These can include origination fees or a fee for an audited financial statement. Have you factored in those costs?
  • Check the terms on supplier finance. When you borrow from a supplier, the true cost can often reach into double-digit percentages. Why? Because the terms often mean you can’t take advantage of cash discounts on the supplier’s product or service. Borrowing from a supplier may also preclude you from buying that same product or service for a lower price from another business.
  • Don’t miss an equity opportunity. People often fixate on the visible cost of debt. But it’s important to remember the equity that’s factored into the cost of your capital. You might get a lower interest rate based on the higher equity you bring to the table. But could you make better use of your equity without committing it to your lender?
    • For example, maybe you need $1 million to run your farm.  You borrow 50%, or $500,000. You still need the other $500,000, so you use money you’ve set aside from profits. But what if you had instead borrowed 80% of the $1 million? You still would have your own untouched money that could be used for another opportunity.

Weighing the Tangibles and Intangibles

Beyond the hard costs, consider capital-cost intangibles. For example, there may be a strong advantage with capital flexibility. Is your lender willing to work with you to help you get where you’re trying to go? Will they give you the freedom to buy what, when and where you want? Does that capital provider want you to give up too much land? Is working with that lender a yearly grind or more aligned as a partner for the future? All that’s worth something, even if your cost may be a little higher.

Evaluate your capital structure from both tangible and intangible perspectives. How can you make yours more flexible, cheaper and more tailored to your operation’s goals? If you’re happy with where your operation is, cheap capital may be good. But if you’re looking to grow, diversify or try something new, paying a little more for capital may bring worthwhile advantages.

With roots dating back to 1932, KCoe Isom is a top 100 accounting firm and the nation’s leading food and agriculture consulting firm.  Its specialists deliver increased value and growth for producers – from policy to plate – with comprehensive strategies and advisory in the areas of financial management, sustainability, farm programs, water and land management strategies, renewable energy and land conservation, and legacy planning.  www.kcoe.com

Published On: February 22, 2022Categories: Bean There Blog

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