In finance, credit refers to the process of obtaining control over the use of money in the present, in exchange for a promise to repay at a future date.

This means that the borrower will have access to money that is not currently their own and will promise to repay based on the terms specified in the loan agreement between the borrower and the lender. In this process, the lender forgoes the use of their money by extending credit to the borrower.

Farmers typically borrow money for two main purposes: production and consumption. This article discusses the various purposes for borrowing and the different classifications of credit.

Production versus Consumption Types of Credit

As highlighted, there are two basic purposes for which borrowed funds are used: production and consumption. Production credit is used for production purposes, such as farming, where the borrower engages in economic activity with the intention of increasing net income after repaying the loan.

This type of loan is dynamic, as it enhances the borrower’s income and facilitates loan repayment. In contrast, consumption credit is used solely for personal consumption. This type of use is static, as it does not increase the borrower’s income or assist with loan repayment when due.

However, not all loans fit neatly into these categories. For instance, when a small farmer borrows money to buy a bicycle, both production and consumption aspects may be involved.

The bicycle might be used to transport harvest from the farm (production credit) and to visit friends (consumption credit). Similarly, if part of the loan is used to purchase a radio, it can be classified as production credit when used for educational programs that improve farm productivity and as consumption credit when used for entertainment.

The Role of Credit in Financing Agribusiness

The role of credit in financing production and consumption for small-scale farmers in developing countries is subject to considerable debate. Many formal credit institutions provide loans for production activities only and avoid lending for consumption purposes. This is understandable from the lenders’ perspective, as farmers using credit for consumption may face difficulties repaying when the loan is due.

Nevertheless, the distinction between production and consumption credit is not always straightforward. For example, institutional agricultural lenders in Tunisia approve loans for feed, shelter, and veterinary services for work animals as legitimate production credit.

However, they disapprove loans for food, clothing, shelter, and health care for farm laborers and their families. In labor-intensive farming systems, where labor is a major input, it is critical for lenders to assess all the inputs used by farmers before approving or disapproving credit applications. Otherwise, lenders risk making the same type of error as seen with the institutional agricultural lenders in Tunisia.

Types of Business Credit in Agribusiness

Classification of Credit in Agribusiness

This discussion focuses on business credit within agribusiness. There are various types or uses of business credit, and a clear classification helps facilitate communication and financial analysis. Although no single classification is entirely satisfactory for all purposes, four primary classifications are often used. The most common classification is based on the time or term of the loan.

Time Classification or Length of Credit in Agribusiness

In the time classification, credit is divided into three categories: short, intermediate, and long terms, based on the loan duration. The following general classification is customary, with further distinctions into monthly, seasonal, and annual loans.

1. Short-term Credit (Production Credit):

i. Monthly (0 – 3 months)

ii. Seasonal (3 – 9 months)

iii. Annual (9 months – 1 year)

Short-term credit, often referred to as seasonal credit, is used to purchase materials that are utilized within a single season or production cycle, such as seeds, fertilizers, labor, and pesticides.

2. Medium-term credit: is used to finance items with a production lifespan covering several years, such as breeding animals.

3. Long-term credit: is typically used for the purchase of land, construction of permanent buildings, clearing trees, and establishing irrigation systems.

4. Intermediate-term Credit (1 – 5 years): Intermediate-term credit is extended for purposes that provide full repayment not in one season but over multiple seasons. It is sometimes defined as loans maturing within a year but renewed annually if the borrower’s income and security are sufficient.

Loans on dairy herds, beef cattle herds, and machinery improvements fall into this category. Additionally, “barnyard” loans, which are written for one year but are not expected to be fully repaid within that time, are often included in this group.

5. Long-term Credit (Real Estate Credit): Long-term loans are distinct, as they are extended on real estate security for periods longer than one year, typically five, ten, or even twenty years, depending on the mortgage lender’s terms.

Overlapping Classification of Short-term and Intermediate-term Credit

Overlapping in the classification of short-term and intermediate-term credit can create confusion. For example, a farmer raising crops may borrow N50,000 annually to finance crop expenses, while a livestock farmer may borrow N50,000 for his herd, renewing the loan annually.

The short-term loan for the crop farmer allows for the production of a cotton crop, while the intermediate-term loan enables the livestock farmer to raise beef calves each year. Although both loans are for the same amount, the cotton farmer requires credit for only a few months, whereas the livestock farmer needs it year-round.

A true intermediate loan finances investments that mature over longer periods, such as orchards, livestock equipment, or irrigation systems. The distinction between short, intermediate, and long-term credit often correlates with loan purpose. Short-term loans are used primarily for producing farm crops and livestock, intermediate-term loans finance working capital assets such as machinery, and long-term loans are typically used to purchase land.

Purpose Classification of Credit in Agribusiness

Purpose classification categorizes loans based on their specific use, facilitating financial analysis to assess the profitability of each loan. This classification includes:

1. Production Loans (Short- and Intermediate-term)

i Buying seed, feed, fertilizer, and hiring labor

ii. Covering operating expenses

iii. Purchasing livestock feeders

iv. Financing fattening livestock

v. Buying dairy cattle

vi. Acquiring machinery or tractors

vii. Financing commodity storage

viii. Refinancing combinations of the above

2. Real Estate Loans (Long-term)

i. Purchasing a farm

ii. Acquiring additional land

iii. Financing buildings, drainage, irrigation, and other improvements

iv. Refinancing combinations of the above

3. Farmer Cooperative Borrowing

i. Covering operating expenses

ii. Financing patrons

iii. Financing commodity storage

iv. Financing buildings, equipment, or real estate purchases

v Refinancing any of the above

Purpose Classification for Investment and Operating Credit

Purpose classification aids in determining whether loans are for investment or operating credit. Long-term loans for land purchases are generally for investment, as the land is not consumed in the production process. In contrast, funds used for farm operations are consumed within one or more production cycles.

For instance, production expenses like seed are used within a year, while machinery, such as a tractor, may last for several years. These distinctions are important for understanding credit use and repayment capacity, as they affect the farm’s cash flow and the farmer’s ability to repay loans.

A challenge with purpose classification arises when loans are used for multiple purposes, as seen in diversified farming operations. Combination loans used for different crops and livestock activities can be difficult to classify into a single category.

Security Classification of Loans

Loans are often classified based on the type of security provided by the borrower. The major classifications include secured and unsecured loans, as follows:

A. Secured Loans:

1. Short- and Intermediate-Term Loans:

i. Chattel mortgage loans for:

ii. Crop

iii. Livestock

iv. Machinery, equipment, or tractor

v. Commodity

vi. Mixed loans.

vii. Warehouse receipt loans.

viii. Loans on collateral securities (such as government bonds).

2. Long-Term Loans:

i. Real estate mortgage loans.

B. Unsecured Loans:

1. Short- and Intermediate-Term Loans

i. Crop

ii. Livestock

iii. Machinery, equipment, or tractor

iv. Commodity

v. Mixed loans

C. Unsecured credit

This is based solely on the borrower’s reputation. For instance, a prominent individual with good standing may receive a loan without providing any collateral. However, if the borrower defaults, the lender has little recourse to recover the funds.

D. Secured short- and intermediate-term loans

These are usually backed by chattel (movable property). Long-term loans, on the other hand, are generally secured by real estate, such as land or buildings. In the case of farm-mortgage loans, failure to repay the loan allows the lender to take over the property.

Small-scale farmers often lack sufficient security to offer lenders. Their assets may only include basic tools, such as hoes or bicycles, which have low values and cannot be accepted as collateral.

Lender Classification

Loans are also classified by the type of lender providing them, which can vary in their policies. Credit can be grouped based on the lender, often in combination with the time classification:

1. Short- and Intermediate-Term Loans (Non-Real Estate)

i. Banks

ii. Production credit associations

iii. Other financing institutions

iv. Commodity credit cooperatives

v. Individuals and others

2. Long-Term Loans (Real Estate):

i. Commercial and savings banks

ii. Insurance companies

iii. Individuals and others

Lenders are further categorized as formal or informal. Formal lenders include government credit institutions, cooperatives, and commercial banks, whose operations are standardized and regulated by the Central Bank. Informal lenders, such as merchants, traders, money lenders, and relatives, operate on a more personal basis, with varying interest rates and lending procedures.

In developing countries like Nigeria, small-scale farmers primarily rely on informal lenders, while larger farmers often obtain credit from formal institutions.

Loans in Cash and Kind

It is recommended that small farmers receive loans in kind (e.g., fertilizers, pesticides, and improved seeds) to prevent the diversion of credit for other uses. However, loans in kind may not always meet the primary needs of small-scale farmers, as hired labor accounts for a significant portion (60-70%) of their credit requirements. Moreover, small farmers may sell inputs received in kind to obtain cash for other purposes, defeating the purpose of the loan.

Repayment Plans

Loans can also be classified based on the repayment plan:

1. Short-Term Loans: These may be repaid in a lump sum (end payment) at the end of the borrowing period or through monthly installments, with interest paid at the end.

2. Long-Term Loans: Repayment is typically done in installments, known as amortization. The borrower pays both the principal and interest in decreasing amounts over time, as demonstrated by a loan example of N1,000,000.00 with a 20% interest rate.

Importance of Lending Institutions

Choosing the right lender is crucial to the success of any farm business. A knowledgeable and experienced lender can offer valuable advice, caution against risky ventures, and help the farmer seize profitable opportunities. The lender serves as a guide, helping the farmer make sound financial decisions, ensuring that funds are used efficiently for maximum returns.

Farmers should evaluate lenders based on their institution type, personnel, loan policies, and past performance in helping other farmers in the community. This information will assist in making an informed decision when selecting the best lender for the farmer’s specific credit needs. Understanding the various types of lending institutions is essential, especially as the financial needs of the agricultural sector continue to grow.

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