DEBRE TABOR UNIVERSITY

COLLEGE OF AGRICULTUR AND ENVIRONMENTAL SCIENCE

DEPARTEMENT OF AGRICULTURAL ECONOMICS

AGRICULTURAL CREDIT AND FINANCE (AgEc 342)

Prepared by: Walelgn Y.

DEBRE TABORE, ETHIOPIA

April, 2024

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Course Objectives
After successful completion of this course students will be able to:
 Define words like finance, rural finance, agricultural finance and microfinance
 Identify the role of rural finance
 Sort out the source of capital (resource) in Agriculture
 Identify the role and classification of credit
 Defining economic activities of a farm business
 Measuring risk and return of a farm business
 Analyze the link between diversification and risk minimization
 Analyze Financial structure and analysis in farm business
 Discuss Risk management and the use of insurance in agribusiness
 Identify available credit instruments and their use
 Comment on problems of rural finance
 Suggest recommendation for rural finance improvement

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 CHAPTER ONE
CONCEPT AND DEFINITIONS
At the end of this chapter, you will except to:
 Define words like Finance, Rural finance, Agricultural finance and Micro finance
 Identify the role of financial system and rural finance for rural development
 Identify and discuss the challenges in rural finance
1.1 Meaning and Scope of Rural Finance
Rural finance, as defined by the world bank, is the provision of a range of financial services
such as savings, credit, payments and insurance to rural individuals, households, and enterprises,
both farm and non-farm, on a sustainable basis.
Rural finance is an important subject matter for small scale farmers and modern farming
businesses. However, rural finance has faced various problems and challenges in which case
there is a common opinion to follow a new approach for successful operation in rural area, and
agriculture as well. There is great deal of ambiguity among finance, rural finance, agricultural
finance and microfinance.
Finance is narrowly interpreted as capital in monetary form that is in terms of funds lent or
borrowed, normally for capital purposes, through financial markets or institutions.
Agricultural finance is defined as a subset of rural finance dedicated to financing agricultural
related activities such as input supply, production, distribution, wholesale, processing and
marketing. Agricultural finance is the economic study of the acquisition and use of capital in
agriculture. Agricultural Finance “as a branch of Agricultural Economics, which deals with
financial resources related to individual farm units.”
Microfinance is the provision of financial services for poor and low-income people and covers
the lower ends of both rural and agriculture finance.
The term rural finance refers to the financial transactions related to both agricultural and non-
agricultural activities that take place among households and institutions in rural areas. In some
cases, rural finance has been wrongly equated with agricultural credit, based on the assumption
that credit is the binding constraint to achieving project objectives related to agriculture. A more
effective and comprehensive view of rural finance encompasses the full range of financial
services that farmers and rural households require, not just credit.

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1.2. Roles and Functions of Agricultural Credit and Finance
 Achievement of economic growth
Access to a range of financial services is necessary in order to achieve economic growth,
including growth in rural areas. Growth in agriculture as well as other rural economic activities
can be substantially enhanced if there is reliable and sufficient financing, and sustainable
financial intermediation, in addition to many other factors.
Moreover, technological revolution including mechanization, improved varieties, modern
chemical pesticides and fertilizers, and new production methods have contributed to the increase
in production per acre, per animal, per labor-hour. These technological and structural changes in
agriculture have increased the risks of owning and operating a farm business. The increased use
of credit in farm business along with narrower profit margins has increased the financial risk of
farming. The importance of finance in agriculture has significantly increased over time in
accordance with the change in technology and the increase in production.
 Inclusion and participation of all members of the rural population in economic development
In many countries, poor rural populations do not have access to financial services even if there is
access for wealthy persons, larger farms and larger rural enterprises. The microfinance
“revolution” has demonstrated conclusively that financial intermediaries that serve the poor, as
well as better-off populations and enterprises can be successful. Access by the poor to financial
services provides them with some of the resources they need to pursue economic opportunities as
well as manage their household finances.
In spite of these, policy should be directed at developing a market-based financial system for
rural finance, but because of market failures to support disadvantaged groups, a special-priority
program may be needed to get credit to women, smallholders and the rural non-formal sector.
Subsidizing interest rates is not the way to help marginal borrowers. Instead, they can be helped
through fixed-cost subsidies and self-selected targeting. Commercial banks should be
encouraged to lend on other bases than the mortgage and passbook system. They should consider
lending for such downstream agricultural activities as agro-processing. To improve rural
financing, the system of property rights, title and default enforcement must also be strengthened,
among other reforms.
 Reduction of vulnerability to economic, physical and other shocks

The poor in general have few resources and are vulnerable to even small swings in income or
unexpected expenses due to illness, death of a family member, seasonal liquidity problems
related to the agricultural calendar, and a wide variety of other factors. The ability to save even
small amounts during good times and keep these sums safely locked away until they are needed
is essential. Another financial product that is important to poor rural populations is the ability to
receive remittances reliably and at a low cost from migrant workers, especially in rural areas that
have poor prospects for economic growth and income generation.

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While there is no conclusive proof that access to financial services has a significant impact on
poverty reduction, there is substantial field-based evidence pointing to the importance of rural
finance for economic development. Most households with economic activities above the
consumption level and most enterprises in rural as well as urban areas need access to financial
services in order to grow and generate income, be they agriculture-based or off-farm.

 Access to finance is also needed for improvements in rural infrastructure such as

telecommunications, energy, irrigation and watershed management, all of which have an
impact on the improvement of people’s lives.

1.3. Challenges in Rural Finance

Rural finance, despite several efforts by donors, governments and private investors to improve it,
Still remains very challenging and is generally weak in developing countries. It is recognized
that rural areas and populations remain underserved, yet economic development for these areas
and populations are key components in the overall development of a country. The donor
community and providers entering the market have shown a renewed interest in economic
growth leading to poverty reduction within rural populations. In spite of their renewed
commitment, significant challenges to the successful implementation of effective delivery of
services and outreach remain prevalent
 Economic challenges:
 Political, legal and institutional challenges
 Cultural and geographical challenge
 Weather challenges
Q, explain each challenge of rural finance?
Economic challenges: Rural finance faces varieties of challenges resulting from the economic
reality of a country including the following:
1). Transaction costs: High transaction costs for both borrowers and lenders;
2). Economic activities: Often limited economic opportunities available to local populations;
3). Risk: High risks faced by potential borrowers and depositors due to the variability of
incomes, exogenous economic shocks and limited tools to manage risk;
4). Collateral: Lack of adequate or usable collateral (lack of assets, unclear property rights);
5). Infrastructure Undeveloped or inadequate infrastructure;

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6). Land fragmentation: Land held may be too small to be sustainable in an optimal use; and
7). Sources of income: Individuals may be dependent upon only one crop with no other external
sources of income.
Political, legal and institutional challenges: The following are some of the political, legal, and
institutional challenges faced in rural finance.
1) Institutional capacity: Weak institutional capacity including poor governance and operating
systems, low staff and management skill;
2) Political intervention: Risk of political intervention, which can undermine payment morale
through debt forgiveness and interest rate caps;
3) Policy: Inhospitable policy, legal and regulatory frameworks;
4) Legal systems: Undeveloped legal systems, inadequate contract enforcement mechanisms;
5) Information: Lack of reliable information about borrowers; and lack of market information
and/or market access.
Cultural and geographical challenge: Cultural and geographical challenges are the common
problems faced in rural finance some of which are listed below:
1) Population density and demand: Generally lower population density and dispersed demand;
2) Repayment culture: History of poor repayment culture, many in the rural populations
historically associate poverty reduction efforts with charity from NGO’s and view the
microfinance institutions in the same way making it a challenge to develop good repayment
behavior; and
3) Accessibility: It is sometimes difficult to gain access to the communities and to get the
community to accept credit terms.
Weather challenges: Developing countries with a great dependence on rain-fed agriculture are
highly influenced by weather related challenges including:
1) Rainfall – Rainfall patterns vary by region resulting in some areas with one growing season
and others;
2) Natural disaster – Susceptibility to natural disasters which can cause sudden and severe
devastation to livelihoods; and
3) Seasonality – potentially affecting both the client and the institution
Unfortunately, financial services providers in rural markets are not able to choose which
challenges they will face. More often than not the various challenges reinforce and compound

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each other. For example, the high risk inherent in agriculture means increased importance in
screening and monitoring of clients and therefore higher transaction costs for both clients and
institutions, which are exacerbated by the dispersion of the client base and small loan sizes.
 Calvin Miller (2004) has identified 12 key challenges in rural finance.
These challenges can be grouped into four as vulnerability constraints, operational constraints,
capacity constraints, and political and regulatory constraints in a country.
Vulnerability constraints: Vulnerability constraints include systematic risk, market risk, and
credit / financial risk arising from the following issues, weather condition, plagues and diseases,
prices, production, useable collateral, demand preferences, and health and family needs.
Operational constraints: These constraints are including low investment returns, low investment
and asset levels, and low geographical dispersions of the rural financial institutions in a country.
These constraints rise from the following, low growth potential, low velocity of capital, non-
competitive technologies, lack of market integration, lack or quality of roads and
communication, low efficiencies of business operations, and high operating costs.

Capacity constraints: Capacity constraints are related to infrastructural capacity, technical and
training capacity, social exclusion, and institutional competency. These are caused by the
following constraints: lack of business investment, lack of competitive technologies, lack of
roads, lack of communication, lack of education, lack of technical and management skills, lack
of institutional capacity, and lack of social representation (civil society).

Political and regulatory constraints: These challenges include political and social interference,
and regulatory framework. They are related to the following challenges: political interference,
NGO donation interference, cultural and gender constraints, land tenure laws, and financial
regulations and tax policy.

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 CHAPTER TWO
RESOURCE ACQUISITION AND USE OF CREDIT IN AGRICULTURE
Objective: at the end of this chapter, you will except to
 Classify sources of funds used to control capital assets
 Explain the concept of credit
 Identify the bases of credit
 Discuss the role/ importance of credit for agricultural activity
 Differentiate the types of rural credit (formal and informal)
 Identify the features/characteristics/ of successful agricultural credit provider
 Classify agricultural credit (loans) based on various criteria
 Discuss the advantages and disadvantages of credit

2.1. Resource Acquisition in Agriculture

The capital requirements of a farm or ranch (a large farm) business are large and increasing due
to inflation, technological change, and increase in farm size. With the need to control land,
machinery, livestock, and other resources worth hundreds of thousands of dollars, many
prospective young farmers as well as policymakers are asking with increasing concern,
Resource acquisition is intended to:
 Limit competition
 Utilize underutilized market power.
 Overcome the problem of slow growth and profitability in one’s own industry.
 Achieve diversification
 Utilize underutilized resources
 Gain economies of scale.
Advantages of Resource Acquisition

 Maintaining /accelerating agricultural /companies’ growth.

 Enhancing profitability through cost reduction resulting from economies of scale
operating efficiently.
 Reducing tax liability because of provision of setting off accumulated losses un absorbed
depreciation of one company against the profit of another.

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Credit is one way acquiring additional capital. But the questions related to the amount, type and
timing are very important for a farmer's decision in acquiring additional funds/capital/. How
should a farmer decide how much credit to use in the farm operation and where to use it? What
are the contributions that credit can make? What types of credit are available? How a farmer can
work with a lender for successful credit?

These resources have various sources including internal and external sources. Sources of funds
used to control capital assets can be classified as equity and non-equity or debt financing. Equity
capital is the capital owned by the operator while non-equity capital is the capital gained from
debt financing. They include savings and retained earnings, gifts and inheritance, pooling equity
capital through a partnership or corporation, leasing, contract farming, and borrowing.

 Savings and Retained Earnings

Assume you get a certain amount of capital. Let its source be either from your own earnings, or
borrowing from your friend or bank. Which source makes you more confident to use? Is there
any source which makes you less confident?
Despite the growing financial barriers to farm business entry, ongoing farm business firms can
use their own capital sources to improve and diversify their farms. However, accumulating the
beginning equity base needed to start farming by saving part of one's earnings from farm or
nonfarm employment is difficult. Because of this limitation of equity capital, farm operators are
required to use non-equity capital.
 Gifts and Inheritances
Because of the dominance of family farm in most countries' agriculture, much of the owner
equity in agriculture can be acquired through gifts and inheritances from the previous generation
of farm operators. The disadvantage of this type of source of capital is that such funds are often
not received when needed most. The availability of such funds for young farmers depends on the
average life expectancy in a country.
 Pooling Equity Capital
There are several methods of combining equity capital in a farm business. One of the most
common is the case where older farmers furnish/provide capital to younger family members
through partnership, incorporation, or some other type of formal or informal agreement.
Although these arrangements are usually made among members of the same family, two or more

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unrelated individuals can pool their equity in a farm business. Formal agreements are not
always necessary to use the equity in an existing operation as a base for growth and
expansion. Informal arrangements for exchanging labor for machinery or possibly renting land
from a successful neighbor or relative can reduce the need for large capital investments and
provide management assistance in the early years.
The primary advantages of pooling equity capital are to take advantage of economies of size and
to distribute risk among two or more persons. Generally, the participants in a farm business
venture should share profits in direct proportion to their respective contributions of labor,
management, and capital. Failure to recognize this basic rule is almost certain to result in an
unsatisfactory arrangement. Other essentials of a successful business organization involving two
or more farmers include the following:
 The goals of all participants should be compatible;
 They should be capable of getting along together and respecting each other's judgment
 The business must be large enough to provide an adequate living for all parties; and
 Good records, sound farm management, and common sense in the handling of money
will help to avoid disagreement.
The pooling of equity capital follows various organizations including partnerships, and
incorporation to pool capital from family members, and non-farm equity capital from nonfarm
investors.
Partnerships: A partnership exists whenever two or more persons associate to conduct a non-
corporate business. Partnership may operate under different degrees of formality, ranging from
informal, oral understandings to formal agreement. In forming a partnership, the participants
should know and understand what is involved and give proper attention to legal aspects. Each
person entering into a partnership assumes considerable responsibility for actions of the other
partners.
Corporation: A corporation is a legal entity authorized by law and is capable of doing business,
making contracts, borrowing money, and the like, just as an individual proprietor. For this and
other reasons, the services of a qualified attorney/lawyer/ are essential for incorporating a farm
business. The advantage of a corporation from a financing stand point is that the owners have
limited liability. There are also a number of disadvantages associated with incorporating a farm
business, and they should be carefully and thoroughly considered. Management of the farm not

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in line with the interest of minority owners, and additional time, expenses, and taxes paid unlike
other farm business organizations are some of the major disadvantages.
 Leasing
A lease is basically a capital transfer agreement that gives the lessee (the user farmer) control
over assets owned by the lesser for a specific period of time for an agreed-upon payment or rent.
Leasing is an alternative to purchase an asset in order to acquire the services of that asset. By
leasing an asset, the lessee essentially acquires its use value from the lesser, which actually
purchased and owns the asset
There are various types of leasing facilities. The major types of leasing common in agriculture
include financial lease, operating lease, and leverage lease.
Financial lease: is a contract that is non-cancelable and the lease period is usually shorter than
the useful life of the asset being leased. During the life of the contract all of the cost of the
property plus financing and servicing charges should be recovered through periodic payments.
The lease assumes complete financial responsibility for the leased asset; and, if operated
successfully, the lesser or owner will recover original investment.
Operating lease፡ is a service available for which there is an established leasing and second-
hand
market. Assets are leased over periods from around six months, shorter periods being more in the
nature of plant hire, up to three years for most types of equipment and machinery. An operating
lease may be alternative when a firm requires a machine for a relatively short period. The
operating lesser function in assuming the obsolescence risk in uncertain circumstances is
comparable to an insurance contract.
Under leverage lease: the lessee assigns his interest in a purchase in order to lesser who agrees
to
advance only a portion of the total asset cost, and arranges to borrow the remaining portion from
institutional lenders.
Leasing covers various assets including real estate, machinery, and livestock leasing.
Real-estate leasing: Leasing is a common way for farmers to obtain control of additional land.
Real estate leases can be the share lease or the cash lease. With a share lease part of a crop or
livestock production is paid to the lesser as rent. With cash leasing arrangements, the lesser is
paid a specified cash payment and usually furnishes the land, building, and other improvements.

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The concepts of cash and share rent are sometimes combined in what is called standing rent. In
this case, in place of cash, the rental payment is made in a fixed measure of products, i.e. the
dollar amount of rent the leasers receives varies with the price of the product, as it would with
share rent, but the amount of product he will receive is known in advance.
Machinery leasing: Purchase of machinery often with borrowed funds is the traditional method
of acquiring control over farm machinery. However, rapidly rising machinery prices have
prompted many farm operators to consider leasing as an alternative to ownership of farm
equipment. It can be operating lease, or financial lease. An operating lease is a short-term
contract in which case the farm operator leases the equipment by the hour, day, week, and
month, etc. The lesser is responsible for insurance, taxes, and major repairs, and the lessee covers
variable expenses such as fuel, lubricants, and routine maintenance. However, there are many
variations of operating lease including custom hiring, an operating lease arrangement whereby
the owner of the equipment furnishes the machine operator in addition to covering all operating
expenses, and a full-service lease, an operating lease contract under which the lesser assumes
total responsibility for all repairs and maintenance costs. The financial lease, in contrast to the
operating lease, is a long-term contract under which the lesser essentially provides financing to
the lessee. Usually, the lessee is responsible for all repairs and maintenance just as if he had
purchased the equipment outright.

However, there are many variations of operating lease including custom hiring, an operating
lease arrangement whereby the owner of the equipment furnishes the machine operator in
addition to covering all operating expenses, and a full-service lease, an operating lease contract
under which the lesser assumes total responsibility for all repairs and maintenance costs. The
financial lease, in contrast to the operating lease, is a long-term contract under which the lesser
essentially provides financing to the lessee. Usually, the lessee is responsible for all repairs and
maintenance just as if he had purchased the equipment outright.
Livestock leasing: The typical livestock-share lease contract usually covers land, buildings, and
livestock. These contracts cover basic herd livestock such as dairy cows, beef cows, and sows.
The lesser assumes fixed ownership costs including depreciation, taxes, and interest on
investment, while the lessee is responsible for variable costs such as feed, housing, veterinary
services, and labor.

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  Contract Farming
An increasing amount of resources used in the farming sector can be furnished by farm input
suppliers, processors, and distributors under various types of producer contracts. Contract faming
is, therefore, a way for an operator to obtain additional funds. Forward contract refers to a futures
contract to buy or sell a specific physical commodity at some
time in the future. There are three basic types of forward contracts used in farming namely
market specification contracts, production-management contracts, and resource-providing
contracts. When the traditional open-market form of market coordination fails to provide the
needed market outlet for input suppliers or farm products of the proper specification at
reasonable prices for marketing firms, market specification contracts can be used. It is an
agreement under which farm inputs or products will be exchanged at some specified future date
at an agreed-upon price (or basis for calculating price). This contract specifies the acreage to be
grown, the price per ton, and in some cases the delivery schedule.

Production-management contracts provide the same features as market specification contracts,

but in addition the farmer receives technical advice and management services from the input
supplier or processor. Market specification and production-management contracts typically do
not provide any financing per se; however, they do have financial implications for the farmer
because lenders tend to look more favorably on a loan application if marketing arrangements are
guaranteed by a producer contract. Under resource-providing contracts the farmer receives
financing from the marketing firm as well as guaranteed market outlet and production
management assistance.

As with any method of acquiring control of assets, contracting has its weaknesses and strengths.
The most important advantage is the financing the farmer receives both directly from the
contracting firms and indirectly through other lenders, who are more assured of loan repayment
when a contract is in existence. In addition to financial help, the farmer usually receives
managerial advice and technical assistance such as production scheduling, high-quality breeding
stock and seed varieties, fertilizer recommendation, veterinary services, custom-blend feed, the
latest equipment, and other supplies and services that might not otherwise be available.

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Contracting also leads to better coordination of production and marketing phases, thereby
resulting in higher profits and reduced risk for both farmers and contracting firms.

Perhaps the most obvious disadvantage of contract production is the loss of managerial control.
The farmer may become little more than a hired hand and may also have to accept lower net
returns to compensate the contracting firm for providing financing and sharing production and
marketing risks. Finally, the farmer loses the opportunity to benefit from higher market prices if
forward prices are specified in the contract.
 Borrowing
Borrowing constitutes the remaining method of farmers use to acquire funds. The word 'borrows'
means to receive something with the understanding that it or its equivalent will be returned as
agreed upon. Stated another way borrowing means the ability to command capital or services
currently for a promise to repay at some future time. In terms of money, borrowing involves
obtaining a certain amount of funds to be repaid as specified in the note. Borrowing is not the
exact synonym of credit.
2.2. Capital Structure, Leverage
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings.
 Leverage
James Horne has defined leverage as, “the employment of an asset or fund for which the
firm pays a fixed cost or fixed return.
Types of Leverages
 Operating Leverage
The leverage associated with investment activities is called as operating leverage. It is caused
due to fixed operating expenses in the company. Operating leverage may be defined as the
company’s ability to use fixed operating costs to magnify the effects of changes in sales on its
earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed
cost and variable cost. When the company is said to have a high degree of operating leverage if it
employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of
operating leverage depends upon the amount of various cost structure.

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 Contribution
• oL=
EBIT
• where contribution means sales minus variables costs
• EBIT means contribution minus fixed costs.
Example. when fixed costs are 1000 birr and variable cost per unit 12 birr to sales 200 units with
selling price per unit 20 birr. Calculated operating leverage
Contribution
• OL= == 2.67
EBIT

 Financial Leverage
Leverage activities with financing activities are called financial leverage. Financial leverage
represents the relationship between the company’s earnings before interest and taxes (EBIT) or
operating profit and the earning available to equity shareholders.
Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify
the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at
a fixed cost in the hope of increasing the return to the shareholders.
“The use of long-term fixed interest-bearing debt and preference share capital along with
share capital is called financial leverage or trading on equity”.
Financial leverage may be favorable or unfavorable depends upon the use of fixed cost funds.
Favorable financial leverage occurs when the company earns more on the assets purchased with
the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage.
Unfavorable financial leverage occurs when the company does not earn as much as the funds
cost. Hence, it is also called as negative financial leverage.

 Combined Leverage
When the company uses both financial and operating leverage to magnification of any change in
sales into a larger relative change in earning per share. Combined leverage is also called as
composite leverage or total leverage. Combined leverage expresses the relationship between the
revenue in the account of sale and the taxable income.

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2.3. Concept, Role and Classification of Credit

According to the free on-line dictionary, credit means faith/believe/ and it comes from the Latin
credito. An agreement, by which something of value-goods, services, or money-is given in
exchange for a promise to pay at a later date. Credit is a transaction between two parties in which
one, acting as creditor or lender, supplies the other, the debtor or borrower, with money, goods,
services, or securities in return for the promise of future payment. As a financial transaction,
credit is the purchase of the present use of money with the promise to pay in the future according
to a pre-arranged schedule and at a specified cost defined by the interest rate

Credit does not necessarily require money. The credit concept can be applied in barter economies
as well, based on the direct exchange of goods and services. However, in modern societies credit
is usually denominated by a unit of account. Unlike money, credit itself cannot act as a unit of
account.
Since credit is a resource that can be used or held in reserve, borrowers and non-borrowers alike
are concerned with several questions. For example, a farmer might ask: How much credit is
available, and how much should be used? What are the costs of credit? What are my legal
obligations as a borrower? Which lender is most likely to be able to serve my credit needs?
How much credit? Credit use will increase return to equity and firm growth rates as long as the
rate of return on capital invested exceeds the cost of borrowing. However, financial risk limits
the amount of credit one can actually uses without jeopardizing the survival of the business. The
question can be answered by understanding the factors that lenders consider in evaluating loan
application.
Credit costs: Borrowing involves several costs, including finance charges, legal fees, closing
costs, etc., and it is sometimes difficult to identify and compare these costs. The only meaningful
way of measuring the cost of credit is to express all charges and fees in terms of a compound
annual rate of interest.
Bases of Credit
Numerous factors influence the creditworthiness /considered suitable to receive commercial
credit/Credit is in turn dependent on the reputation or creditworthiness of the entity which takes
responsibility for the funds/of a farmer. Lenders, especially bankers, use a formula known as the
seven C's of credit when evaluating a credit application. Understanding them will help you make
your applications as attractive as possible. Which mean credit managers usually talk of the C's of
credit: character, capacity, collateral, capital, condition, courage, and competition?
1. Character: Character or integrity is the most important factor of confidence. This is
essentially a summary of the individual. Creditors look for people who appear to be trustworthy
and reliable, and who are willing and able to meet their financial obligations. The first step in

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selling one's credit to a lender is to be honest in all business and personal dealings, because the
confidence factor is vitally important.
2. Capacity (or risk-bearing ability): Risk-bearing ability measures whether the farm operation
can withstand financial losses without being forced into liquidation or insolvency. If production
and prices decline and losses occur, they must be absorbed or covered by equity capital or net
worth. The basic document used to measure the risk-bearing ability of the farm business is the
balance sheet. The key ratios used in the analysis of risk-bearing ability are those related to total
assets, or debt to equity. These ratios show the proportion of the business financed with debt
compared to owner's equity and thus indicate the claims by others on the asset if liquidation
should occur. This simply means the individual's ability to repay the loan; it is based on present
and anticipated earnings balanced against existing debts.
3. Collateral: Collateral security is any security (other than personal security such a guarantee)
taken by a bank or lender when it tends to make an advance to a borrowing customer, and which
is entitled to claim in the event of default. Hence, the presence or absence of collateral matters to
get credit. The item pledged by the borrower as security for the loan, which may be real state,
stocks, savings, a mortgage, etc.
4. Capital (or repayment capacity): A lender wants to be paid in cash; he has little interest in
repossessing the security or collateral as satisfaction of the debt obligation. The ability to repay a
loan is consequently an important determinant of whether credit should be extended and is
influenced by the income-generating capacity of the business; the liquidity of the farm as
indicated by the balance sheet, and the cash flow of the firm. In short run an indication of
repayment capacity is that if current assets are not sufficient to pay current liabilities a repayment
problem will very likely occur as an indication of repayment capacity in short run. In long run
the key issue is whether there is sufficient revenue after paying for operating expenses, family
living, and farm expansion to repay any debt obligation. This is the net worth on an individual as
indicated by a personal financial statement
5. Condition (or return): It is a combination of all the relevant facts about an agribusiness firm
and its situation in the existing economic environment. The basic question with respect to returns
are whether or not the use of credit will add to potential profits. Only if the profits of the business
will be increased will there be additional income available to make principal and interest
payments on the borrowed capital. Two questions are of interest in evaluating income or returns.

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The first is the issue of whether the planned use of credit is the most profitable use in the farm
business. The second question with respect to the returns is whether the farm business is
generating an adequate income to compensate for contributions of family labor and management
as well as for equity accumulation. The profitability of the entire farm operations must be
evaluated to assess the possibility of income generated from profitable enterprises to cover losses
on unprofitable ones. Both regulatory and economic conditions are considered. Regulatory
conditions apply to the lender’s individual circumstances; for example, when banks are not
lending in specific areas. Economic conditions determine the lender's general policy towards
loan. Both are affected by the current economic cycle.
6. Credit: this is the individual's credit history
7. Competition: The extent of competition to extend credit also matters to get credit. If there is
no sufficient number of competitors involved in the financial market (in credit extension), getting
credit may be difficult and vice versa.
 Role of Credit
At a certain stage in agricultural development, agricultural credit clearly does become a strong
force for further improvement –when a man with energy and initiative who lacks only the
resources for more and more efficient production is enabled by the use of credit to eliminate the
one block on his path to improvement. Financial credit is the most flexible form of transferring
economic resources to the poor. One can buy anything that is for sale with cash obtained through
credit.
According to Kebede (1995), credit makes traditional agriculture more productive through the
purchase of farm equipment and other agricultural inputs, the introduction of modern irrigation
system and other technological developments. Credit can also be used as an instrument for
market stability. Rural farmers can build their bargaining power by establishing storage
facilities and providing transport system acquired through credit. Credit plays a key role in
covering consumption deficits of farm households. This would, in turn, enable the farm family to
work efficiently in agricultural activities. Credit can further be used as an income transfer
mechanism to remove the inequalities in income distribution among the small, middle, and big
farmers. Moreover, credit encourages savings and savings held with rural financial institutions
that could be channeled to farmers for use in agricultural production. Credit also creates
employment opportunities for rural farmers.

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Additionally, credit is important and necessary in nearly all commercial and individual farm
businesses. The potential to improve net farm income should be one of the determining factors in
the decision of whether to use credit. Credit can contribute in the improvement of net income in
several ways:
1. Create and maintain an adequate size. Most farms exhibit decreasing costs as the size of
the business increases because of economies of size;
2. Increase efficiency. Use of credit increases substitution, utilization of idle resources, and
intensity of production to secure efficient use of resources;
3. Adjust to changing economic conditions of technology and market;
4. Meet to seasonal and annual fluctuations in income and expenditures;
5. Protect against adverse conditions of weather, disease, and price; and
6. Provide continuity of business during transfer.
 Types of rural credit
There is typically a dual rural credit market in developing countries, formal and informal credit.
In the formal credit markets institutions provide intermediation between depositors and lenders
charge relatively low rates of interest that usually are government subsidized. In informal credit
markets money is lent by private individuals, professional moneylenders, traders, commission
agents, land lords, friends and relatives.
Formal and informal credits are imperfect substitutes. In particular, formal credit, whenever
available, reduces, but not completely eliminates, informal borrowing. This suggests that the two
forms of credit fulfill different functions in the household’s inter-temporal transfer of resources.
Informal credit is used perhaps for consumption-smoothing purposes, while formal credit is
sought and used mostly for agricultural production purposes and investment in non-farm income
generating activities. The empirical evidence also suggests that the imperfect substitutability.
 Classification of Credit
There are many different types of business credit, and proper classification will facilitate
communication and financial analysis. Primary classifications are presented here based on time
and purpose
Classification by time: Based on the length of the terms of loans, credit can be classified into
three:
A. Short-term credit (production credit):

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  Monthly credit (0-3 months);
 Seasonal credit (3-9 months); and
 Annual credit (9-1 year).
B. Intermediate-term credit: 1-10 years.
C. Long-term credit: Real-estate credit (more than 10 years).
Classification by purpose: This classification can facilitate analysis of the profitability of a
specific loan if records as to income and expenses are kept.
A. Production loans (short-term and intermediate-term loans): Used to buy inputs, pay
operating expenses, buy feeder livestock, range livestock, dairy cattle, machinery, and
finance storage.
D. Consumption loans: Any loan advanced for some purpose other than production is broadly
categorized as consumption loan. These loans seem to be unproductive but indirectly assist in
more productive use of the crop loans i.e. without diverting then to other purposes.
Lender’s classification: Credit is also classified on the basis of lender such as
 Institutional credit: Here are loans are advanced by the institutional agencies like co-
operatives, commercial banks. Ex: Co-operative loans and commercial bank loans.
 Non-institutional credit: Here the individual persons will lend the loans Ex: Loans given
by professional and agricultural money lenders, traders, commission agents, relatives,
friends, etc.
Borrower’s classification: The credit is also classified on the basis of type of borrower. This
classification has equity considerations.
 Based on the business activity like farmers, dairy farmers, poultry farmers, pisciculture
farmers, rural artisans etc.
 Based on size of the farm: agricultural laborer, marginal farmers, small farmers, medium
farmers, large farmers
Based on contact:
 Direct Loans: Loans extended to the farmers directly are called direct loans. Ex: Crop
loans.
 Indirect loans: Loans given to the agro-based firms like fertilizer and pesticide industries,
which are indirectly beneficial to the farmers are called indirect loans.
2.4. Advantages and Disadvantages of credit

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Advantages of Credit
Modern economy is said to be a credit economy. Credit is of vital importance for the working of
an economy. It is the oil of the wheel of trade and industry and helps in the economic prosperity
of a country in the following ways:
1. Economical: credit is used as an engine/motor/ of the economy
2. Increases productivity of capital: Credit increases the productivity of capital. People having
idle money deposits it in banks and with non-bank financial institutions which is lent to trade
and industry for productive uses.
3. Convenient: Credit instruments are a convenient mode of national and international
payments. They help in transferring payments with little cost and without the use of actual
money from one place to another quickly.
4. Internal and external trade: As a corollary to the above by facilitating payments quickly,
credit helps in the expansion of internal and external trade of a country.
5. Encourages investment: Credit is the payment along which production travels, and that
bankers provide facilities to manufacturers/farmers/ to produce to full capacity. Credit
encourages investment in the economy. Financial institutions help mobilizing savings of the
people through deposits, bonds, etc. These are, in turn, given as credit to trade, industry,
agriculture, etc. which lead to more production and employment.
6. Increases demand: A variability of cheap and easy credit increases the demand for goods
and services in the country. This leads to increase in the production of such durable consumer
goods. These raise the standard of living of the people when they consume more goods and
services. Consumption loans by banking and non-banking financial institutions coupled with the
use of credit cards have made these possible.
7.Utilizes resources: Credit helps in the proper utilization of a country's manpower and other
resources. Cheap and easy credit encourages people to start their own businesses which
provide them employment. Agriculture develops when farmers get seeds, fertilizers, pumping
sets, tractors, etc. on credit. Similarly, transport, communications, industry, mines, plantations,
power, etc. develop with the help of credit.
8. Price stability: Credit helps in maintaining price stability in a country. The central bank
controls price fluctuations through its credit control policy. It reduces the credit supply to
control inflation and increases the supply of credit to control deflation.

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9. Helpful to government: Credit helps the government in meeting exigencies or emergencies
when the usual fiscal measures fail to fill the financial needs of the government. Government
 Disadvantages of Credit
Credit is a dangerous tool if it is not properly controlled and managed. The following are some of
the defects of credit
1. Too much and too little credit harmful: Too much and too little of credit are harmful for
the economy. Too much of credit leads to inflation which causes direct and immediate
damage to creditors and consumers. On the contrary, too little of credit leads to deflation
which brings down the level of output, employment and income.
2. Growth of monopolies: Too much of credit leads to the concentration of capital and wealth
in the hands of a few capitalists. This leads to growth of monopolies which exploit both
consumers and workers.
3. Wastage of resources: When banks create excessive credit, it may be used for productive
and unproductive purposes. If too much of credit is used for production, it leads to over
capitalization and over production, and consequently to wastage of resources. Similarly, if credit
is given liberally for productive purposes; it also leads to wastage of resources.
4. Cyclical fluctuations: When there is an excess supply of credit, it leads to a boom. When it
contracts, there is a slump. In a boom, output, employment and income increase which lead to
over production. On the contrary, they decline during a depression thereby leading to under
consumption. Such cyclical fluctuations bring about untold miseries to the people.
5.Extravagance: Easy availability of credit leads to extravagance on the part of people. People
indulge in conspicuous consumption. They buy those goods which they do not need. With
borrowed money, they spend recklessly on luxury articles. The same is the case with
businessmen and even governments who invest in unproductive enterprises and schemes.
7. Black money: Excessive supply of credit encourages people to amass money and wealth. For
this they tend to adopt underhand means and exploit others. To become rich, they evade taxes,
conceal income and wealth and thus, hoard black money.
8. Political instability: Over issue of credit leading to hyper-inflation leads to political
instability and even the downfall of government.

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