Agricultural finance plays a crucial role in the theory of agricultural development, which is fundamentally viewed as a process involving the adoption of new and improved agricultural practices by farmers. Many of these practices require financial resources to purchase necessary inputs, highlighting the importance of capital in agricultural business.

Agricultural credit includes all loans and advances provided to borrowers to finance and support production activities related to agriculture. Farm credits, whether for production, current expenses, or long-term capital needs, are typically categorized into short-term, medium-term, and long-term finance based on their duration.

Internal Sources of Finance for Farm Business

Internal and External Sources of Capital for Farm Business

Internal finance refers to the mobilization of resources within a firm to fund agricultural activities. It involves utilizing funds generated from within the business, such as retained earnings, to finance operations. Key internal sources of finance include:

1. Retained Profit/Earnings

Retained profit is one of the most significant yet often overlooked sources of finance in agribusiness. While managers may be aware of these funds, they might not fully understand how to utilize them effectively. Retained earnings serve as a valuable source of long-term finance, provided the agribusiness is profitable after meeting all obligations.

2. Sale of Assets

A farm can generate funds by selling assets such as machinery, vehicles, or fixtures. In some cases, the farm may sell assets and lease them back when needed. While this approach might result in higher costs over time, it provides immediate cash flow to address urgent financial needs or avoid crises.

3. Reducing Stocks

Stocks, including raw materials, semi-finished products, and harvested crops, can be sold to raise funds. While holding onto stocks can be beneficial if consumer demand or prices are expected to rise, excessive stockpiles may indicate low demand, making it challenging to liquidate them. Reducing stocks involves speculation about price fluctuations and market conditions.

4. Equity Capital

Equity capital is generated through profits reinvested into the business or by bringing in additional investors. This source of finance is particularly important for small or new businesses seeking to expand their capital base. However, owners may hesitate to sell equity to avoid losing control over their business operations.

5. Common Stock

For small businesses, issuing common stock to employees or community members interested in investing can be a viable option. Common stock typically grants voting rights, allowing investors to participate in management decisions. Larger businesses may issue stock to the public, requiring the assistance of investment brokers, auditors, and lawyers.

External Sources of Finance for Farm Business

External sources of finance can be categorized into institutional (formal) and non-institutional (informal) sources.

A. Non-Institutional Sources

Non-institutional or informal sources lack standardized lending procedures, interest rates, or collateral requirements. These sources are prevalent in communities where lenders and borrowers share mutual trust and familiarity.

1. The “Esusu”: The “Esusu” is a collective fund where a group of individuals contributes a fixed amount of money, which is then given to one member at a time. Loans or advances from this fund are typically interest-free and prioritize members in urgent need.

2. Ajo: In the “Ajo” system, individuals contribute a fixed amount daily. The collector safeguards the funds and distributes the total savings at the end of the month, deducting a fee equivalent to one day’s contribution.

3. Money Lenders: Money lenders, often from outside the rural community, provide loans at high interest rates. Farmers who pledge their lands or crops as collateral risk losing them if they fail to repay the loans.

4. Friends and Relations: Loans from friends and relatives are part of cultural practices where prosperous individuals assist less fortunate family members or acquaintances. In some cases, these loans are not repaid.

5. Personal Savings of the Farmer: Farmers may use personal savings to purchase inputs for production. While personal savings are considered an external source, they are treated as loans to the business, which are expected to be repaid in the future.

6. Institutional Sources: Institutional sources provide capital to agribusinesses through recognized entities that follow standardized lending procedures. These sources typically offer larger loans compared to non-institutional sources and require collateral.

7. Commercial Banks: Commercial banks raise funds through deposits and provide loans to businesses and consumers. They offer short-term, medium-term, and long-term loans, as well as lines of credit. Examples in Nigeria include United Bank of Africa (UBA) Plc., First Bank of Nigeria Plc., and Union Bank of Nigeria Plc.

8. Leasing or Renting: Leasing involves renting equipment, warehouses, or other fixed assets for a specified period. While leasing avoids the need for large upfront investments, it often costs more than traditional loans. Businesses may opt for leasing to allocate funds toward expansion rather than asset acquisition.

9. Accounts Receivable Loans: These loans use a business’s accounts receivable as collateral. In a notification arrangement, the bank informs debtors to make payments directly to it. In a non-notification arrangement, the borrower collects receivables and forwards them to the bank. Non-notification loans often involve higher record-keeping costs and reduced managerial flexibility.

Warehouse Receipts and Other Financial Tools for Farm Business

Warehouse receipts and other financial instruments play a vital role in helping agribusinesses manage their working capital and secure funding. These tools enable farmers and agribusinesses to leverage their assets, build relationships with financial institutions, and access credit on favorable terms. Below is an overview of these financial mechanisms and their relevance to farm business.

1. Warehouse Receipts

Warehouse receipts allow farmers to use their inventory as collateral for loans. This type of financing is only applicable to non-perishable items and helps businesses operate with limited working capital. The process involves selling the inventory to the bank and then buying back the receipts. This arrangement provides liquidity while retaining ownership of the stored goods.

Banks may also offer personal unsecured loans to borrowers with a strong reputation or financial standing. However, this poses a risk to lenders, as repayment is not guaranteed if the borrower defaults. Secured loans, such as mortgages on real property, equipment, or loans against life insurance policies, stocks, and bonds, are more common and less risky for lenders.

2. Trade Credit

Trade credit is a common practice in agribusiness, where farmers purchase goods and services upfront and pay for them later. Suppliers and vendors often extend credit to farmers in the form of inputs or supplies, especially if the business is creditworthy. Farm managers can negotiate longer credit terms with suppliers, effectively turning them into a cost-free source of financing. Prompt payment to suppliers fosters strong relationships and ensures continued access to credit.

3. Insurance Companies

Insurance companies invest funds collected from policyholders into businesses, including agribusinesses. They typically prefer intermediate and long-term loans secured by fixed assets such as real estate or equipment.

Farmers with insurance policies can often borrow against the cash value of their policies at attractive interest rates. Examples of insurance companies in Nigeria include the Nigerian Agricultural Insurance Corporation (NAIC), Industrial and General Insurance Company Ltd. (IGI), and Leadway Assurance.

4. Cooperative Banks

Cooperative banks are member-owned financial institutions that provide savings and borrowing facilities at lower costs than traditional commercial banks. Unlike profit-driven commercial banks, cooperative banks prioritize service to their members, who are often rural farmers, artisans, and small business owners.

These banks operate on a smaller scale and are typically located in rural areas, offering a personalized approach to banking. Their staff, often from rural communities, understand the unique challenges faced by their customers.

5. Promissory Notes

A promissory note is a written promise by a borrower to repay a specific amount of money with interest after a agreed period. These notes can be negotiated, meaning the holder can sell them to a third party, who then assumes the right to collect the debt.

Farmers and agribusinesses can sell promissory notes to banks at a discount if they need immediate cash. This financial tool is widely used by agribusinesses, banks, private individuals, and creditors.

6. Community Banks

Community banks are self-sustaining financial institutions owned and managed by local communities. They provide credit, accept deposits, and offer banking services to members based on self-recognition and creditworthiness.

In Nigeria, community banks were established to mobilize rural savings, promote rural development, and support micro-enterprises. Their goal is to enhance rural incomes and alleviate poverty by stimulating productive activities in rural areas.

7. Bonds

Bonds are debt instruments that can be secured or unsecured. Secured bonds are backed by collateral such as real estate or equipment, while unsecured bonds (debentures) rely solely on the issuer’s reputation. Bonds provide a way for agribusinesses to raise capital for long-term projects or expansions.