CHAPTER 5: AGRICULTURAL FINANCE

MEANING AND SCOPE OF AGRICULTURAL FINANCE AND CREDIT

Finance can be defined as the art and science of managing money. Finance is concerned with the
process, institutions, markets involved in the transfer of money among and between individuals,
businesses and governments.

Not all rural finance is agricultural or microfinance and not all agricultural finance are rural.
Yet financial service providers offer:
 rural finance (financial services used in rural areas by people of all income levels),
 microfinance (financial services for poor and low-income people), and
 agricultural finance (financing of agriculture-related activities, from production to market)
often have overlapping objectives and opportunities.

The clients served by microfinance are often the same clients or households that would benefit
from increased rural or agricultural finance. The financial systems approach in micro and rural
finance—which emphasizes a favorable policy environment and institution-building—has
improved the overall effectiveness of rural finance interventions. But numerous challenges
remain, especially in financing agribusiness.

Suppliers of rural and agricultural finance can be broadly categorized as:

 Value Chain Actors: exporters/wholesalers; processors; local traders; producer groups;
farmers; and input suppliers.
 Financial Institutions:
o banks (commercial, agricultural banks, state development banks)
o non-bank financial institutions
o not-for-profit MFIs, which tend to work with poorer clients' credit unions and agricultural
cooperatives

DEFINITION: AGRICULTURAL FINANCE AND CREDIT

1
 Loans, notes, bills of exchange, and bankers' acceptances are some of the credit instruments
financing agricultural transactions. Banks lend to farmers for a variety of purposes, including:
1. Short-term credit to cover operating expenses;
2. Intermediate credit for investment in farm equipment and real estate improvements;
3. Long-term credit for acquisition of farm real estate and construction financing; and
4. Debt repayment and refinancing.

Commercial banks are the largest source of agricultural credit, followed by the Farm Credit
Banks. Nationwide cooperative system of banks and associations are providing credit to farmers,
agricultural concerns, and related businesses. The system is comprised of the Banks for
Cooperatives; which makes loans to farmer-owned marketing, supply, and service cooperatives,
and rural utilities.

5.1. SOURCES OF AGRICULTURAL FINANCE

Finance is essential for a business’s operation, development and expansion. Finance is the core
limiting factor for most businesses and therefore, it is crucial for businesses to manage their
financial resources properly. The main source of credit for many farmers and agribusinesses is
other agribusinesses along the value chain including input suppliers, traders, and processors.
Moreover, the clients’ own savings and credit from financial institutions continues to play a role
in agricultural production.

Finance is available to a business from a variety of sources both internal and external. It is also
crucial for businesses to choose the most appropriate source of finance for its several needs as
different sources have their own benefits and costs. Sources of finance can be classified based on
a number of factors. They can be classified as Internal and External, Short-term and Long-term
or Equity and Debt. It would be uncomplicated to classify the sources as internal and external.

I. Internal sources of finance: Internal sources of finance are the funds readily available
within the organization. Internal sources of finance consist of:
 Personal savings
 Working capital

2
  Retained profits
 Sale of fixed assets
II. External sources of finance: External sources of finance are from sources that are outside
the business. External sources of finance can either be:
o Ownership capital or Non-ownership capital
a) Ownership capital: Ownership capital is the money invested in the business by the
owners themselves. It can be the capital funding by owners and partners or it can also
be share bought by the shareholders of a company. There are mainly two main types
of shares. They are:
 Ordinary shares
 Preference shares
b) Non-ownership capital: Unlike ownership capital, non-ownership capital does not allow the
lender to participate in profit-sharing or to influence how the business is run. The main
obligations of non-ownership capital are to pay back the borrowed sum of money and
interest. Different types of non-ownership capital:
o Debentures
o Grant
o Bank overdraft
o Venture capital
o Loan
o Factoring
o Hire-purchase
o Invoice discounting
o Lease

5.2. ECONOMIC FEASIBILITY TEST OF A CREDIT PROPOSAL (CREDIT

WORTHINESS ANALYSIS)
The technological advancement achieved in agriculture made the agriculture capital intensive.
The farmers need credit at right time, through right agency and in adequate quantity to realize
maximum productivity. This is from farmer’s point of view. In contrast to the farmer’s point of

3
view, when a farmer approaches a lending agency with a loan proposal, the lender should be
convinced about the economic viability of the proposed investments.

Credit proposal is one of the main steps in credit processing, which include all the track records
and information of the customer. When the economic feasibility of the credit is being observed,
three basic financial aspects are to be assessed by the creditor. If the loan is advanced, will it
generate returns more than costs? Will the returns have surplus, to repay the loan when it falls
due? Will the farmer stand up to the risk and uncertainty in farming? These three financial
aspects are known as 3 Rs of credit, which are: returns from the proposed investment, repayment
capacity the investment generates, and risk- bearing ability of the farmer-borrower. The 3 Rs of
credit are sound indicators of credit worthiness of the farmers.

a) Loan Appraisal: This is about analysis of repayment capacity and how to appraise
information collected about an applicant's character, capital and collateral position. The
process of cash flow and balance sheet analysis is examined and key interpretation ratios are
introduced. The key elements of loan appraisal are an assessment of the applicant's:

a) Repayment capacity, which can be done through cash flow analysis, Repayment capacity is
the ability of the farmer to repay the loan obtained for the productive purpose within a
stipulated period as fixed by the lending agency. At times, the loan may be productive
enough to generate additional income but may not be productive enough to repay the loan
amount. Hence, the necessary condition here is that the loan amount should not only
profitable but also have potential for repayment of the loan amount. Under such conditions,
only the farmer will get the loan amount.

The repayment capacity not only depends on returns, but also on other quantitative and
qualitative factors as given below:
Y= f ( X1 , X 2 , X 3 , X 4 ___ X 5 , X 6 , X 7 ...)
Where, Y is the dependent variable i.e., the repayment capacity. The independent variables, X1 to
X 4 are considered as quantitative factors while X 5 to X 7 are considered as qualitative factors.
X1 = Gross returns from the enterprise for which the loan was taken during a season in ETB,

4
X 2 = Working expenses in ETB,
X 3 = Family consumption expenditure in ETB,
X 4 = Other loans due in ETB,
X 5 = Literacy,
X 6 = Managerial skill,
X 7 = Moral characters (honesty, integrity etc.).
 character or personal creditworthiness,
 Capital and collateral, which can be determined through a balance sheet.

b) Cash Flow Analysis: All the income and expenditure information that has been collected
during the field trip is now consolidated in a cash flow projection. The exact period of the
projection depends on the envisaged loan term. In agricultural households, one year
projections are common because they encompass the majority of crop growing seasons. Once
a cash-flow projection has been prepared for all the economic activities of all household
members, and all the family expenditure has been incorporated, it needs to be assessed in
relation to the loan proposal. The most commonly used indicators for doing this are:

 the accumulated repayment capacity; and

 net cash flow after loan repayment or "free net cash flow"
c) Sensitivity and Risk Analysis (Risk bearing ability): It is the ability of a farmer to
withstand the risk, which arises due to financial loss. Risk can be quantified by statistical
techniques such as coefficient of variation, standard deviation, and other programming
models.

In order to find out how a cash flow might be affected by adverse factors, the loan assessment
may include a sensitivity and risk analysis. The objective is to know whether adverse
circumstances would undermine the repayment capacity to such a degree that the loan repayment
will be at risk. Factors to be considered in the sensitivity analysis of cash-flow projections could
include:
 Reduced yields due to bad weather conditions, diseases or pests;

5
  Delays in payments, e.g. delays in payments for crops after harvest;
 Lower than expected sale prices;
 Higher input costs;
 Additional labor costs, e.g. replacing a sick family member with hired labor.

When analyzing a cash-flow, these risk mitigating techniques must be taken into account as part
of the risk profile of a farm household. Here are some examples:
 Diversification of income sources
 Family safety networks
 Liquidation of assets

The measures that can be taken to strengthen the risk bearing ability of the farmer include
increasing the owner’s equity/net worth, reducing the farm and family expenditure, developing
the moral character (i.e. honesty, integrity, dependability and feeling the responsibility etc. all
these qualities put together are also called as credit rating), Undertaking the reliable and stable
enterprises (enterprises giving the guaranteed and steady income), improving the ability to
borrow funds during good and bad times of crop production, improving the ability to earn and
save money (a part of the farm earnings should be saved by the farmer so as to meet the
uncertainty in future) and taking up of crop, livestock and machinery insurance.

d) Character Assessment: The information obtained during the field visit, the results of the
careful review of the client history and the cross-checking with other information sources
must now be combined in a final assessment of the personal creditworthiness of the loan
applicant. These include:
a. Disclosure of required information
b. Reputation within the community
c. Good credit history
e) Capital: As the next step of the loan appraisal, a brief analysis of the balance sheet should be
carried out to assess the applicant's capital position. It is not as critical as the cash flow
projection but we can gain some useful insights into a business, even that of a small farmer,

6
 from a balance sheet. Here is a reminder of the balance sheet layout, followed by examples of
things you could look out for:
1. Large amounts of cash
2. The existence of savings
3. Accounts receivable
4. The amount of total assets
5. Accounts payable
6. The value of the existing agricultural stocks
7. The composition of fixed assets
8. Level of indebtedness – expressing liabilities as a percentage of total assets indicate what
proportion of the farm’s assets has been financed through borrowing.

9. Equity percentage – it is the mirror image of the level of indebtedness. It is the equity or
owner's capital expressed as a percentage of total assets.

f) Collateral: Another purpose of examining the asset and liability structure in the balance
sheet is to identify appropriate collateral. The following conditions need to be fulfilled for
any asset that would be accepted as collateral:
1. Importance to the borrower 3. Marketability
2. Value

5.3. LOAN TERMS AND REPAYMENT PLANS

Methods and Mechanics of Processing Loan Application

The financing bank is vested with the full powers to either accept or reject the loan application of
a farmer. This is nothing but the appraisal of farm credit proposals or procedures and formalities
followed in the processing of loans. The processing procedure of a loan application can be dealt
under the following ten steps.

7
a) Interview with the farmer;
b) Submission of loan application by the farmer;
c) Scrutiny of records;
d) Visit to the farmer’s field before sanction of loan;
e) Criteria for loan eligibility;
f) Sanction of loan;
g) Submission of requisite documents;
h) Disbursement of loan;
i) Post-credit follow-up measures; and
j) Recovery of loan

Loan Approval and Follow-up

In this part we will examine the steps that follow loan appraisal, including the approval process,
setting loan terms and conditions, loan disbursement and loan monitoring. Let us now have a
closer look at the various steps that follow loan appraisal.
1. The Loan file: As a first step, the loan officer prepares a loan file in accordance with a pre-
defined structure. It is useful to have a standard checklist of the information and documents
that are needed for a complete loan file.
The following five key aspects of this step:
a. Brief description of the economic activities of the farm household (main crops, livestock
etc.);
b. Brief risk profile of the farm household and details of risk-mitigating strategies that are
used;
c. Characteristics of the loan applied for and the recommendation from the loan officer;
d. Financial indicators:
I. Accumulated repayment capacity indicator,
II. Free net cash-flow indicator,
III. Indebtedness ratio;
e) Rating results as regards personal creditworthiness.
2. Loan Terms and Conditions: A very important part of preparing the loan file that will be
presented is determining the most appropriate loan terms and conditions. Repayment schedules

8
must be in line with the cash-flow patterns of the farmer. Depending on the household situation,
different options exist for appropriate repayment plans in agricultural households:
1. Equal (monthly) installments of loan principal and interest;
2. Regular monthly interest payments and a bulk payment of loan principal at maturity;
3. Regular monthly interest payments and irregular intermediate loan principal payments
when cash is available.

The repayment of medium and long-term loans is different from that of short-term loans because
they are characterized by their partially liquidating nature. These loans are recovered by a given
number of installments depending up on the nature of the asset and the amount advanced for the
asset under consideration. There are six types of repayment plans:
a) Straight-end repayment plan or single repayment plan or lump sum repayment plan
b) Partial repayment plan or Balloon repayment plan
c) Amortized repayment plan
I.Amortized decreasing repayment plan
II.Amortized even repayment plan or Equated annual installment method
d) Variable repayment plan (or) Quasi-variable repayment plan
e) Optional repayment plan
f) Reserve repayment plan (or) Future repayment plan

3. Lending Decision
Lending decisions are normally taken by a credit committee. Decision-making should be
decentralized, i.e. take place as close to the relevant customers and loan officers as possible. This
is essential if large distances exist between branches and district, regional or head offices.
Another reason for decentralizing credit decision-making is that a good loan decision depends on
having good knowledge of the specific economic situation of the client group, the agricultural
activities and the regional context.

A credit committee should consist of at least one person in addition to the loan officer. Loan
officers should not vote on the credit committee but should rather present the information and
provide a clear recommendation for loan approval or rejection.

9
4. Disbursement Programs
Once the loan decision has been made, clients should be informed immediately. Since farmers
generally live far away from the central office, it is important to let them know the date on which
the application will be presented to the credit committee, and when a decision can be expected.
Reducing useless travel time for loan applicants is good client service and reduces the transaction
costs of the borrower. There are various methods that can be used for loan disbursement:
 Cash disbursement. Many lending institutions disburse loans in cash. They either do these
themselves through their own cashiers or by handing out a cheque that can be cashed at a
partner-bank.
 Money transfer to supplier. Some organizations prefer to transfer the approved loan
amount directly to suppliers. This can increase the level of control over how the loan amount
is being spent.
 Supplying inputs in-kind. This method was common in the 1970’s and 1980’s. Many
agricultural lending institutions bought agricultural inputs and then disbursed them as credit
in kind. In-kind loans, however, have the severe disadvantage that the lender becomes
directly connected to the economic success of the investment. If the investment fails, farmers
are then more likely to refuse to repay.

Whatever disbursement method is chosen, however, it is imperative that the loan is available to
the farmer at the moment when it is needed. Late disbursement can undermine the entire
investment, put the income flows at risk and, hence, endanger the loan repayment. The cash flow
budget should indicate clearly when disbursement is required.

5. Loan Monitoring
The success or failure of any financial institution is closely tied to the quality of its loan portfolio
and its loan monitoring system. The assessment of repayment capacity and the creditworthiness
of an applicant provide the basis for good loan decisions and thus, portfolio quality. There are
some key requirements for an appropriate monitoring system for agricultural loans:
a. Open communication between the lender and the borrower is essential for effective loan
monitoring.

10
b. Loan files must contain all the documents (loan application, loan assessment, collateral
records, memos, loan agreement, etc.) which provide a loan officer and other interested
parties with a complete historical and on-going record of the relationship between the lender
and the borrower. These files are the backbone of a loan monitoring system.
c. Computerization should be introduced, if it is not already in place.

Various strategies can be employed to monitor loan performance:

I. Periodic direct monitoring of clients
 Client visits
II. Indirect monitoring of clients
 Attending local markets, cattle auctions, agricultural fairs
 Meetings with extension officers
 Meetings with veterinary officers
 Contacts with agricultural input suppliers, traders, slaughter houses, etc.
 Other client records in the financial institution
III. Monitoring actual loan repayment performance

5.4. THE OLD AND NEW AGRICULTURAL CREDIT POLICIES IN ETHIOPIA:

AFTER FINANCIAL LIBERALIZATION
The development of the financial sector in Ethiopia has a long history and included an array of
banking and non-banking institutions. The financial system comprised of commercial banks,
development banks, specialized financial institutions, cooperatives, insurance companies, etc.
The organizational structure, management and ownership of these financial institutions as well as
their performance have been changing under the different regimes. Ethiopia should give priority
to the peasant agriculture in its national development efforts since development cannot take place
without giving special considerations to the majority of the rural population.

Financial liberalization is an extremely important component of a successful development

strategy. Both economic theory and practical experience suggest that financial liberalization can
stimulate economic development. It is advocated that financially repressed systems should
abolish or relax interest rate controls; eliminate or greatly reduce controls on allocation of credit;

11
switch to market based indirect methods of money supply control; and develop money and
capital markets.

Following financial liberalization, market determination of the interest rates is expected to result
in positive real interest rates. These in turn will increase the resources available to the financial
system, since bank deposits offering competitive return will attract savings that were previously
held outside the formal financial sector. Moreover, positive real interest rates will provide an
incentive for borrowers to invest in more productive activities, thereby improving the
productivity of the economy as a whole. Consequently, financial liberalization should lead to an
increase in both the quantity and the quality of financial intermediation by the banking system.

Following the overthrow of the Derge regime, changes in economic policies as well as political,
administrative and institutional structures began to be introduced by the new government. Hence,
several policies, legal, regulatory, supervisory and institutional reforms have been undertaken by
the new government. The government adopted a World Bank/IMF supported structural
Adjustment Programmes (SAP). The policy reforms involved among other things, reducing
budget deficits and government reliance on domestic bank borrowing, developing more flexible
monetary policy instruments, liberalizing interest rates, and improving efficiency of financial
intermediation by removing distortions in financial resources mobilization and allocation.

Financial liberalization in Ethiopia began at the end of 1992. The financial reform undertaken in
Ethiopia include elimination of priority access to credit, interest rate liberalization, restructuring
and introduction of profitability criteria, reduced direct government control on financial
intermediaries and limits bank loans to the government, enhancement of the supervisory,
regulatory and legal infrastructure of the NBE, allowing private financial intermediaries through
new entry of domestic private intermediaries (rather than privatization of the existing ones) and
introduction of treasury bills auction markets. As a result of the liberalization, nominal interest
rates on deposits and loans were raised by 60 – 90% and 58-144% in 1992, respectively. Prior to
1992, the interest rate charged to farmers’ cooperatives was 5 percent which is below the rate of
savings deposit (6 percent). Financial institutions were obliged to pay interest margin on deposits
from their own sources. Lending rates which were between 4.5 and 9.5 % were raised to 11-15%

12
depending on the sector until September 1994. Deposit rates which ranged between 1 & 7.5% for
time deposit, and 6% for savings deposits were raised to 10-12%. Discrimination of credit access
and interest rates by type of ownership (i.e. between state owned enterprises, cooperatives and
private firms) were eliminated. Sectoral interest rates discrimination was reduced, and domestic
establishment of private financial institutions was allowed and encouraged through proclamation
number 29/1992 (NBE, 1992).

Further liberalization eliminated sectoral discrimination of lending rates, which had continued
(favoring agriculture and housing construction with reduced rates). Since January 1995, the NBE
switched to a policy of floors on deposits and ceilings on lending rates, allowing banks to set
interest rates (NBE, 1995). These rates combined with low inflation resulted in positive real
rates. Further interest rates liberalization was taken in 2001/02. The government saw the need to
review the interest rates to encourage savings through the banks and to create a disincentive to
forestall speculation and uneconomic use of savings by borrowers. The interest rate policy was
reviewed with the following objectives: (1) to keep the general level of interest rates positive in
real terms in order to encourage savings and to contribute to the maintenance of financial
stability; (2) to allow greater flexibility and encourage greater competition among the banks and
non-bank financial institutions to enhance efficient allocation of financial resources – in
particular, the policy strove to ensure that funds flowed into those areas that are most productive.
Hence, the NBE revised the floor for saving deposits downwards to 3% from 6% in 2001/02 with
an intention of encouraging investment and boost economic activity. Lending rates quickly
followed suit as the minimum lending rate charged by commercial banks went down from 10.5%
to 7.5% in the same period.

The liberalization also raised nominal yields on treasury bills and bonds to 12% and 13%
respectively, since 1992. Later a government securities market was established in January 1995
through the introduction of monthly (later biweekly) auction of 91 days' treasury bills with 28
days and 182 days bills added in 1996. Treasury bills are now on offer to financial institution,
business firms as well as the general public. Interest rate liberalization was accompanied by other
reforms including the floating of the exchange rate and trade liberalization. The government also
sought to strengthen the legal and technical capacity of the central bank to carry out its

13
regulatory and supervisory functions. The 1960 Civil Code with respect to sale of bank collateral
has also been amended in 1997 by proclamation (FDRE, 1997). This amendment provides for an
agreement with the borrower authorizing lending banks to sell directly and quickly collateral
from delinquent borrowers. This contributed to the effectiveness of enforcement of credit
contracts. In addition, restructuring of the financial institutions was felt necessary to promote
competition, reduce government ownership and control, balance the type of institutions
(commercial banks, development and household savings banks), and upgrade services. The state
owned banks were restructured financially and operationally. Changes in corporate governance
have been introduced: banks have management autonomy and their own boards; management
have been replaced and reorganized; new incentive schemes have been introduced; and banks are
to operate in a competitive environment using commercial criteria. Banks are no longer required
to specialize their credit services to certain sectors of the economy. They also no longer face
restrictions on the types and sources of deposits they accept. Banks are also decentralizing loan
decision making in order to reduce transaction costs of borrowing and reducing screening hence
transaction costs of lending. Entry restrictions into banking were lifted for domestic banks. Entry
rules and guidelines have been drawn.

The lending approaches of banks to target beneficiaries could be both a direct type and a two tier
system. The direct type is in which the Bank extends credit directly to the end user. This could be
an individual person or organization such as cooperatives, government or private enterprises
which have legal entity. In the two tier approach, the Bank transfers its financial resources to end
users through other bodies such as cooperatives and peasant associations. In the case of the first
type, the credit beneficiaries enter loan agreements with the bank and are responsible for
repayment of the borrowed loan, whereas in the case of the latter other intermediaries such as
cooperatives or associations sign a loan contract with the bank and channel the borrowed fund to
their members or end users.

In the case of rural Ethiopia, regional governments act as intermediaries between banks and
farmers. These governments use their federally allocated budget as collateral to borrow from
banks and on lend these funds to farmers for the purchase of agricultural inputs. This procedure
has enabled banks to lend a great deal of money to farmers. Nevertheless, there have been cases

14
of default, which have necessitated repayment out of the budget allocations of the regional
administrations.

However, the inability of the formal financial sector to provide adequate financial services to
small farmers and the poor in general continued even after the reform. A study by the National
Bank of Ethiopia (1996) concluded that CBE and DBE have only catered for insignificant
demand for credit of small farmers. The bulk of financial services provided to small and micro
enterprises in rural and urban areas, therefore, mostly originated from the informal sector such as
Iqqub, money lenders and friends” (NBE, 1996).

15