Extending advanced payments to farmers is a widespread business practice across numerous countries globally.
In many parts of the world, farmers often find themselves in economically challenging situations, seeking support from prominent agribusiness companies or other sources to fund their farming or harvesting cycles. In such scenarios, they frequently request advances to kickstart their farming endeavors. To secure this initial financial backing, they approach significant agricultural entities, proposing a unique arrangement: instead of repaying the loan in cash, they commit to delivering a portion of their harvest as repayment.
Various types of prepayment agreements exist, hinging on factors such as the loan duration and whether interest is involved. These agreements are shaped by the practices of individual agribusiness companies.
The agribusiness company assesses the creditworthiness of a farmer and decides on the amount of prepayment to be granted. These prepayment disbursements can occur in multiple installments, continuing until the maximum stipulated amount in the prepayment agreement is achieved.
For the eventual recovery of these prepayments, the prepayment agreement(s) will be linked to purchase contract(s) with the farmer. The retrieval of the principal, and potentially any interest, takes place through the settlement of deliveries associated with contracts covered under the prepayment agreement.
A prepayment occurs when a counterparty, typically a farmer, requests a financial advance, either in cash or as account credit, before delivering the purchased product. The value of the prepayment is recovered by the company issuing it through the subsequent delivery of the purchased product.
On the sales side, prepayments can also occur when a company requires a down payment from a customer in order to release a shipment to them.
A third category of prepayment involves a combination of purchase and sales scenarios, where a counterparty pays using grain, and the company must represent this transaction with an internal financial transfer.
Agribusiness companies require a solution not only to issue prepayments to their counterparties, but also to efficiently manage the recovery process through timely settlement.
There are three main categories of prepayment:
- Advance (known as a Spot in Brazil)
- Pre-Finance
- Barter
Prepayment Requests
Prepayments between counterparties are also a common business practice, especially when buying or selling large shipments of soft commodities.
We call them prepayment requests. These prepayment requests are typically made either at the time of contract entry (can also happen later) or at the time of nominating a shipment (which typically means before the cargo is loaded). Prepayment requests are typically not up to the total amount of the entire contract value, but cover a good portion of it.
Prepayments are requested directly with reference to the contract or nomination.
Later, during settlement, the already received prepayment amount from the prepayment request is deducted from the calculated settlement amount, and only the remainder will be invoiced to the counterparty.
All of the above cases can occur with contracts having different pricing conditions (Flat, NFE, NBE, NPE) and various currencies. It is also possible to have different currencies in the commodity contract and the financial contract (for example, a commodity contract in R$ and a financial contract in USD). This disparity affects the calculation of the releasable amount and the monitoring of the contract lifecycle.
Business Process Flow Alongside the Standard SAP Agricultural Contract Management Process Flow
For the eventual recovery of these prepayments, the prepayment agreement(s) will be linked to purchase contract(s) with the farmer. The retrieval of the principal, and potentially any interest, takes place through the settlement of deliveries associated with contracts covered under the prepayment agreement.
Prepayments Types and Characteristics
Delving deeper into the types of prepayments, we encounter diverse scenarios that cater to distinct needs. Firstly, there's the context where we extend financial assistance to small-scale farmers. On the other hand, corporations also harness this process to secure advances before engaging in transactions with other companies.
Prepayments with farmers primarily transpire on the purchasing side, involving procuring grains directly from them. However, the landscape shifts when prepayments interlink corporate entities. Both purchasing and sales facets are encompassed in this scenario.
Prepayment Types
Advance/Spot: When the company has a contract to buy from a supplier, but the company chooses to delay delivery to after the contractual delivery period. In this case, the company might advance the payment for what was scheduled to be delivered
- Typically, physical goods are delivered in the next 90 days (could be as much as 120 days later)
- In some regions (like Europe), this is decided on at a shipment level. This means there could be multiple advances per contract
- Because of the nature of this type of prepayment, typically there is no interest charged
- Sometimes a credit analysis is performed prior to disbursement
- Known as a Spot in South America
Pre-Finance: When the company gives money to a supplier in advance of shipments. This money typically goes towards helping the farmer operate the farm (seeds, fertilizer, maintenance, and so on) and is linked to future commodity contracts
- Money is often provided more than 6 months in advance of expected deliveries
- Credit checks are almost always present (as is collateral)
- Interest charges are almost always present
Barter: When the company is exchanging supplies for commodity products and netting receivables for one against payables for the other
Typically, where one business unit of the agriculture company provides products and services (for example, agronomy services and seeds) instead of direct cash and the farmer pays down their account balance using their harvested grain
Real-Life Advance Scenarios
Imagine ABC Agriculture has a contract with a small-scale farmer. This agreement involves the delivery of bushels of grains in October. However, there are instances when the silos lack sufficient space for immediate delivery. To navigate this, companies often opt to retain the harvest for a brief period and then arrange for its delivery later. Here's how it unfolds:
ABC Agriculture has a contract for 5,000 BU of soybeans with Farmer XYZ for October delivery. Due to a big harvest, silos are full and ABC Agriculture asks Farmer XYZ to hold off on delivering until January. As part of asking Farmer XYZ to delay delivery, ABC Agriculture agrees to pay in advance for the grain that will be shipped later.
To calculate how much should be prepaid, contract factors need to be considered:
- 5,000 BU @ $11.20 / BU = $56,000
- Contract has destination incoterms, so no delivery charge impact
- Miscellaneous fees and expected quality-based discounts come out to $500
- Local policy is to pay 95% of this amount
- Total prepayment amount: $52,725
As the grain comes in, the $52,725 will be "recovered" following some rule. In this scenario, it would be likely for the advance amount to pay for the entire grain amount until it runs out.
Prefinance
In this situation, the farmer requires financial support to initiate the harvest cycle, procure seeds, and equipment. They opt for a loan from ABC Agriculture, pledging to deliver a specified quantity of grains, say, bushels. This prepayment occurs in multiple chunks over time.
ABC Agriculture is working with Farmer XYZ in Brazil and Farmer XYZ needs to invest in equipment, fertilizer, and seeds. Farmer XYZ is looking for a $500,000 loan to get going on this year's planting season.
As part of this pre-finance process, ABC Agriculture wants to make sure they have physical contracts with Farmer XYZ to at least cover the $500,000, as well as checking to make sure Farmer XYZ is "good for the money".
This agreement likely isn't a one-call type of transaction, as Farmer XYZ will need to provide references and might need collateral as well. Based on creditworthiness, interest rates are established (these can be flat or floating/reference interest rates) and based on company policy, the interest methods (how the interest is charged) are established.
The pre-finance money will be distributed in two chunks - $300,000 in September and an additional $200,000 in November. Because the grain isn't expected to be delivered until March/April, ABC Agriculture will be charging interest (as already discussed). At the end of each month, starting with September, ABC Agriculture will accrue for expected interest revenues.
As the grain starts to come in, the $500,000 + interest will be recovered following rules set by the business. Depending on the expected overall value of the contracts tied to the prepayment, it might make sense for X % (for example 70%) of the value of the shipment to go against the prepayment and ABC Agriculture to pay Farmer XYZ for 30% of the load until the balance of the prepayment is fully recovered. As the prepayment amount is recovered (using grain settlement), the system tracks how much is applied to the principal vs interest.
Barter
In cases where monetary transactions are less suitable, the barter approach comes into play. ABC Agriculture exchanges fertilizers, seeds, or equipment with the farmer, instead of monetary prepayment. This exchange can be at the outset or during the harvest cycle. Interest charges can vary based on the situation. Interest might be applicable during the initial stage, but not later.
ABC Agriculture has both an agronomy and an origination division. Farmer XYZ buys their fertilizer and seeds from ABC Agronomy and sells some of their crop to ABC Origination. Farmer XYZ has a contract to buy fertilizer for crop A from ABC and a contract to sell crop B from ABC for the same delivery month. After contracting for both, Farmer XYZ calls in to ask if they can use the grain deliveries to pay for the fertilizer.
Although the fertilizer is flat priced at the time the contract is agreed to, the grain only has the basis fixed, so the grain-to-fertilizer exchange needs to be negotiated. Because the cash is going to be recovered in a short-term, there are no interest charges. Because the buying and selling organizations are different (even if they're in the same legal entity), an intracompany (or intercompany) transaction needs to be recorded.