Signaling Credit Risk in Agriculture: Implications for Capital Structure Analysis

Abstract

Signaling is an important element in the lender-borrower relationship that influences the cost and availability of debt capital to agricultural borrowers. This paper analyzes the effects of signaling on farm capital structure in conjunction with the pecking order and trade-off theories. The aggregate estimation indicates that signaling does affect agricultural credit relationships through measures of past cash flow and profitability. High-quality borrowers achieve greater credit capacity by providing lenders with valid signals of their financial status, while adjusting toward target debt levels over time and following the pecking order relationship in the short run.Key Words: farm businesses, pecking order theory, signaling theory, trade-off theorySignaling is an important element in the lender-borrower relationship that directly influences the cost and availability of debt capital to agricultural borrowers. It is based on the premise that lenders prefer to finance higher-quality borrowers with lower credit risk. In determining a borrower's credit capacity, lenders need information that allows them to accurately distinguish between highand low-quality borrowers, thus minimizing adverse selection problems. High-quality borrowers strive to inform lenders of their status by sending credible, unambiguous, and meaningful signals. In contrast, low-quality borrowers are unable to send such signals.Although signaling is a generic strategy applicable to many types of relationships, the signaling instruments for financial relationships rely on measures of strong financial performance (e.g., high profitability and cash flow) that strengthen risk ratings made by financial institutions.The sensitivity of farmers' credit capacity to various financial characteristics and risk management was conceptualized by Baker, empirically tested in several studies, and found to differ significantly among such factors as farmers' use of crop insurance, forward contracting, choice of lender, financing instrument, income variability, asset structure, enterprise mix, and degree of vertical coordination (Barry and Robison). These studies are consistent with the signaling paradigm to various degrees, although Baker's approach was motivated primarily by liquidity considerations, while more recent studies have emphasized agency relationships, asymmetric information, and incentive alignments between borrowers and lenders (Hart; Hubbard; Jensen and Meckling).

Impact of debt structure on production efficiency and financial performance of Broadacre farms in Western Australia

“…Zhao et al . () analysed the financial effects of signalling on farm's credit capacity and investment conditions for crop farms in Illinois. Their results indicated that signalling affects agricultural credit relationships between lenders and borrowers.…”

How to deal with global concept of Risk in Agriculture? Comparative overview of the literature

“…Some studies (e.g. [7], [8], [14] and others) have verified their new proposed risk evaluation model on a sample of data of farms. These studies therefore also included the practical application of the proposed risk evaluation models.…”

Qualitative and quantitative analysis of micro and macro aspects of agricultural finance

“…Internal equity and debt are the major financing alternatives, while external equity and direct access to capital markets are beyond the reach of most farms. Nonetheless, capital intensity of farm businesses is high, production cycles can be lengthy and seasonal, life cycle effects are present, and rates of return on assets are relatively low and volatile (Zhao et al, 2008 Ratio analysis is often used as a tool of financial analysis within the agricultural sector (Katchova and Enlow, 2013). If we compare results from the previous two tables (microaspect: analysis of business success), we can see that the agricultural companies of Serbia have even 10 times higher share of financing responsibilities compared to Slovenia (growth of indebtedness), whereas they have even 3 times lower coefficient of stock turnover (poor sales and cash management).…”