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The financing of agricultural cooperatives: An expanded financial base can make cooperatives more effective

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1982
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Turto Turtiainen and J.D. Von Pischke

Agricultural service cooperatives have a great potential to promote growth in the rural areas of the developing world. They can, and do, bring people and funds together to provide a broad range of pre-harvest and postharvest services to farmers. Multipurpose cooperatives, the most modern form in the agricultural sector, provide both types of services—from the supply of credit, farm inputs (like fertilizer and seeds), and machinery to storage, processing, and marketing services.

In spite of an often poor financial record, agricultural cooperatives have proliferated, partly because they appeal both to governments and to farmers. Governments like them for several reasons: they mobilize self-help resources that might otherwise be left unused; they attract assistance from foreign cooperative societies and aid agencies; and they offer the authorities an established base that could be used either to achieve social welfare objectives or to implement development programs in the rural sector. This latter attraction of cooperatives is particularly appealing in countries where the government has a limited institutional presence in the rural areas. Farmers, on the other hand, seem to be attracted by the idea of cooperatives whether for ideological reasons or for the economic benefits cooperatives can offer their members in the form of government subsidies and the economies of scale that result from collective action. Many agricultural activities, for instance, require more capital investment than a farmer can, or will, provide alone. A cooperative venture can draw in funds from other farmers and attract outside financing to support its activities.

But too often in developing countries these cooperatives are ineffective. There are a number of reasons: bad debts and excessive overdue payments caused or exacerbated by poor and untrained management, and faltering support by members in difficult times. And—although in most countries it is no longer a problem—the traditional dominance of cooperatives by well-off segments of the population (often the moneylenders and traders that cooperatives were supposed to supplant) left them with a bad reputation among poorer people. Many of these problems could be overcome if cooperatives were run more efficiently.

A possibly even more pervasive and intractable problem is that governments frequently attempt to make cooperatives play a role in development for which their financial structure is not suited. Cooperatives, by definition, depend heavily on their members for patronage and financial support. The members’ ability to use cooperative services and their readiness to leave their funds with them determine the ability of cooperatives to expand, very often even to compete effectively in supplying credit or services to their membership. If, therefore, national priorities mean that cooperatives have to expand their activities to serve a broader function—to redistribute incomes, for instance—then their finances must be strengthened. They must either be subsidized, with provisions for the subsidy to be paid off over some specified period, or they must be able to raise additional financing from sources other than their membership.

Financial base

The principles, practice, legal basis, performance criteria, and financing structure of cooperatives are not the same as those of private companies or state enterprises, although they have many features in common. The most significant difference is the dependence of cooperatives on their membership for business as well as debt financing—a characteristic that can limit their expansion and make them financially vulnerable in developing countries.

Cooperatives are not profit-seeking institutions; surplus earnings are normally distributed to members largely as patronage refunds determined by the volume of each member’s transactions with the cooperative. As a result, they tend not to accumulate capital beyond the amount needed to stay in business. In principle, they can raise extra funds either from the sale of shares to members or from the private market and institutions such as other cooperatives or banks.

Selling shares to members has limits; in most countries the number of prospective members is restricted by the “common-bond” principle, which confines membership to a geographic area or to a particular occupation. Members are, moreover, not encouraged to buy shares because more shares do not buy more voting power in the cooperative. In addition, the shares that the members do own do not form a truly permanent capital base for the cooperative, since they are redeemable at cost and have no marketable value. The value of each share, too, is low, usually equal to US$2-5, so as not to exclude potential members. On the other hand, cooperative shares are generally unattractive to private investors, partly because cooperative law in most countries limits the returns that can be paid on them (to ensure that they are an inexpensive source of funds to societies) and partly because of their poor financial performance. In addition, the tradition of favoring small cooperatives has had adverse effects on their capital base.

Keeping cooperatives small so that all members know each other has been regarded as more important than having a larger membership with a broader potential capital base. However, since the 1960s, large cooperatives, especially in cooperative marketing, have become more common. In Kenya, most coffee cooperatives have over a thousand members, and in India the average membership of agricultural cooperatives is approaching one thousand.

Agricultural service cooperatives have traditionally raised most of their funds from their members. Experience shows, however, that although members’ share capital may be sufficient to start certain activities, such as cooperative marketing, it cannot finance most of the undertakings of agricultural service cooperatives in developing countries today—especially enterprises whose capital requirements are substantial, whose functions are complex, and whose results are expected within a short period of time. Large-scale operations and entry into food-processing and other capital-intensive activities, for instance, require much more capital than individual members are able to provide within the time horizon of a development project—even assuming that members feel that they have a sufficient stake in their society and confidence in its management and future to want to buy more shares in it. In this situation, modifications to the traditional cooperative tools for raising capital may be required.

Expanding basic capital

Efforts have been made in some developing countries to adapt the financial structure of cooperatives to enable them to expand their capital. This has included accumulating—instead of distributing—surpluses and raising funds from sources other than members.

Some cooperatives have tried to accumulate capital or reserves by issuing shares to members out of annual surpluses, usually in proportion to their patronage of the society’s services—for example, in relation to the amount of milk marketed through the cooperative by each member. This is typical in developed areas such as Scandinavia and is also gradually being adopted in developing countries. For instance in Kenya, a very prominent cooperative dairy industry is partly based on such an arrangement. Another means of capitalizing a cooperative, practiced for example in India, is to sell shares to other cooperatives that operate in the same sector and would benefit from the improved and expanded activities of the society. Annual surpluses, if not distributed as bonuses, may also contribute to cooperative capital through reserve formation.

Selling shares or building up reserves out of annual surpluses has proven a difficult route to follow, however. The orientation of a cooperative to service its members usually means that it sells at low prices or adopts cost-plus pricing, rather than looking for profits at prices the market will bear. This tends to lead to low returns, especially in today’s inflationary environment. Legislators have attempted to secure some capital base for cooperatives by requiring the allocation of part of each annual surplus to statutory reserves. Examples of such practices are found in India, Kenya, Tanzania, and Zambia. In all these countries, 10–25 per cent of the annual surplus has to be transferred to reserves.

Since agricultural service cooperatives do not normally have easy independent access to the standard sources of debt and equity, such as capital markets, alternatives have been devised in several parts of the world, including the sale of shares to institutions and governments and the sale of debt to members.

Institutional funds usually come from cooperative banks established to support cooperatives, and sometimes at less than market rates. The original capital usually comes from the government or external sources but has recently been increasingly derived from savings, so that some cooperative banks have become fully independent of government financing. For instance, the Maharashtra State Cooperative Bank in India, with assets of over Rs 4 billion (approximately $500 million) obtains all its resources from cooperatives and cooperative members. Strong cooperative banks already exist in such developing countries as India, Kenya, Mauritius, and Uganda.

In some others, such as Egypt and Tanzania, general agricultural or development banks are the main source of investment finance. Governments and public bodies are also important sources of debt for large cooperative investments in several countries. Debentures with fixed interest rates and repayment dates have proved a stable source of cooperative long-term debt in countries as diverse as India and the United States, where their marketability is supported by some form of government support or privilege. They are probably the most promising source of new finance in most countries, particularly for well established cooperative enterprises. International borrowing other than from development assistance agencies is also gradually becoming more important. Even commercial banks have proved to be important sources of borrowed finance for the expansion of cooperatives in, for instance, Liberia, Somalia, and Zambia.

To raise capital, cooperatives incur debt for which they may have to pay market rates of interest. Societies other than credit and savings cooperatives often collect deposits or receive loans from their members at negligible rates, and well-established cooperatives, like the coffee processing and marketing cooperatives in Kenya, may form banking units. Members of primary societies may be persuaded to take a portion of their patronage refunds in the form of fixed-term debt, which is very typical in North America and gradually spreading to developing countries. They may also receive payment for their produce over an extended period of time. This commonly happens for internationally marketed cash crops, such as coffee, sugar, cotton, and cocoa.

Diversification and the invention of new sources of cooperative finance become even more important as rural cooperatives increasingly integrate their operations vertically from basic production to distribution, which requires much larger investments than the most typical form of cooperative activity, marketing. Prominent examples of such cooperative enterprises are fertilizer factories in India, cold storage in Egypt, dairies in Kenya, and fish-processing factories in South Korea. For instance, the third cooperative fertilizer plant in India, completed a couple of years ago, cost over $220 million, of which one half was borrowed from the World Bank.

A national role

Governments in developing countries use cooperatives for many noneconomic reasons, for example, to benefit certain groups or to operate in areas when other organizations are absent, or, where relevant, to provide technical assistance, such as expertise, educational materials, or improved internal management techniques for accounting and auditing or preparation for future undertakings. For instance, in India, multipurpose rural cooperatives are the most effective rural institutions available and other development efforts can be centered around them. The extensive Scandinavian assistance to cooperatives in Eastern Africa (Kenya, Mozambique, Tanzania, and Zambia) shows how governments use cooperatives to combine local efforts and foreign expertise and aid both to improve the quality of cooperative operations and to direct more of the benefits to poorer sections of the population. The number of small farmers and poor people belonging to cooperatives has increased simultaneously with the improved operational methods and increased per capita income.

In many low-income countries, government policy determines the functions and goals of agricultural service cooperatives. Yet this policy may frequently be at odds with the financial structure of cooperatives and may arguably have been a major cause of their apparent ineffectiveness. Cooperatives at the field level should ideally be oriented toward their members’ economic advancement. Yet, optimization of members’ economic benefits may not be possible if governments use cooperatives to promote broader policy objectives. Government priorities may, for instance, require restrictions on profit or service margins, mandate increased agricultural lending at a rate that exceeds the administrative capacity of the cooperative, or lead cooperatives to provide services below their cost. In India and Egypt, practically all profit margins and service fees of cooperative operations are controlled by the government. Some of them, such as fertilizer prices, often lag behind actual costs, thus burdening the cooperatives’ financial position. Yet all experience so far shows that cooperatives can contribute meaningfully to development in the long run only if they are effective and sufficiently profitable business organizations. Agricultural service cooperatives are especially prone to being used by government in a way that conflicts with their financial basis. The control of fees or margins by the government is usually unnecessary because, given its principles, a service cooperative must be sufficiently efficient in providing services that the prices or commissions charged to cover their costs do not exceed a level at which member patronage becomes unattractive.

In the interest of all participants, a cooperative should develop rationally, be staffed by suitable personnel, maintain a sound financial structure to ensure solvency and liquidity, build firmly established business relations and procedures, and strive for other basic positive qualities essential for commercial survival. The nonprofit orientation of cooperatives is often emphasized. This approach may be attractive in the short term, but it is not workable in the long run if members are unable to provide the volume of transactions required for the commercial success of the cooperative, much less contribute toward its capitalization through retained surpluses. Subsidies should be provided where legitimate social motivations justify the establishment and continuation of cooperatives but preclude their financial viability in commercial terms. Such assistance has been provided, for example, in Zambia, where cooperatives were promoted to secure production and marketing of staple foods.

Cooperative financial analysis

The first indication of the financial acceptability of an investment is obtained from its income and expenditure projections. Since a cooperative belongs primarily to its members, its activities must provide sufficient income to cover its expenditures and the repayment of its loans, irrespective of any social or economic benefits to the country. If the government considers the social, political, or economic implications of the cooperative’s operations important, the cooperators would be fully justified in insisting on the reimbursement of resulting losses or a change in government pricing regulations applied to the cooperative.

The cooperative’s income statement and the analysis of its sources and uses of funds reveal where its funds come from and how they are used, and show whether the project or enterprise will be sufficiently liquid and when cash shortages may occur. Temporary cash deficits for individual years need not create alarm if sufficient funds have been accumulated or if short-term borrowing is possible. If longer-term (cumulative) cash flow is negative, corrective action must be taken, perhaps by changing prices of goods and services, by reducing costs, or by altering the activities or investment plans of the cooperative.

Trend and ratio analyses are used to determine the efficiency and effectiveness of business operations. As such, their application to service organizations not oriented toward the accumulation of profits, such as agricultural cooperatives, may be resisted—rightly or wrongly—by project sponsors and designers. The “necessary services by least costs” method of analysis is often applied to projects of this type. This approach is advocated by many cooperative officials when political or other non-economic reasons determine the activities of agricultural cooperatives.

A difficulty in using the least cost method is determining the “acceptable” cost of services. Even when cooperatives are given a monopoly, they cannot charge any price they like. In fact, in many instances, their service margins are fixed arbitrarily at low levels by government. Standards of acceptable costs are required. As cooperatives are intended to be permanent and operate in a businesslike manner, performance and financial standards or targets are necessary. Management of cooperatives to the satisfaction of their interest groups (members, staff, government, or customers) is hardly possible without budgets and standards. Standards may be set using selected ratios, or other quantitative or even qualitative targets.

Only a well-selected combination of criteria can accurately reflect progress toward multiple objectives. Ratios and standards would be selected to reflect the nature of the cooperatives under study. Allowances may be necessary for different circumstances and size. The diversity of cooperatives requires one caution: figures used for comparison should cover the measured variable as comprehensively and uniformly as possible. Adjustments are often needed because some useful data is not provided directly by the balance sheet and income statement. For example, the net surplus is only one indicator of the overall financial result. If taxes and depreciation are added to it, a more useful picture is given. Some analysis requires going beyond the cooperative’s accounts, such as derivation of the “service surplus.” This surplus is created when the cooperative price or fee is lower than that which the market would bear or which competitors use.

Financial analysis of cooperatives uses the same categories of ratios and standards that are commonly applied to other forms of enterprise. This is even more true for cooperatives engaging in capital-intensive projects. Usual ratios are those describing solvency, stability (or liquidity), profitability, and efficiency (also called productivity). However, financial ratios are only numbers. Judgment is required for their interpretation. One way of interpreting cooperatives’ financial ratios is to compare them with those of other cooperatives engaged in similar activities or with norms for the industry in which the cooperatives operate. Yet those ratios may appear out of line due to the specific nature of the cooperatives being analyzed. However, on comparative grounds, they serve as a basis for further examination to identify reasons for divergent performance. When these are understood, judgments may be made concerning the quality of the cooperatives’ performance relative to their objectives, specializations, expectations, and raison d’être.

A fundamental function of cooperatives is to improve members’ economic conditions through self-help. Prospering cooperatives also indirectly benefit the whole society. However, if their socioeconomic performance were measured using social analysis methods developed in the World Bank and elsewhere, cooperatives could appear more attractive than when they are assessed by financial analysis alone. This is because they tend to serve poorer sections of society and because of their broad regional spread and their labor-intensive methods. Yet, it is necessary to caution against using cooperatives as tools of social development beyond the limits determined by their financial strength or so that members’ economic benefits and interests suffer because of transfers to nonmembers. Government controls, intended to protect cooperatives, can easily result in transfers of this type and endanger the supporting members’ interests and the long-term financial viability of cooperative enterprises.

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