To summarize what we have covered so far:
Cooperative capital formation is essential for survival in a competitive, risky world. Successful capital formation strategies require the creation of a surplus in normal and good years.
Financial self-sufficiency, based on member capital, institutional capital and outside commercial sources of funding, is the basis for successful commercial cooperation. Debt ratios should be carefully managed, as over-indebtedness leads to bankruptcy.
Successful cooperatives innovate in the development of their businesses and in their capitalization strategies and methods. Those with a strong equity base are able to borrow from commercial sources.
Successful cooperatives mobilize capital from their members in a variety of ways.
And most importantly, improvements in cooperative capital structure require members to be active in their dual role as investors and users.
These five points are based on the goal of self-reliance - the cooperative ideal of being masters of ones own destiny by uniting in collective action. So let us assume that we agree with the above and want to encourage more member investment in the cooperative. Where do we start?
As noted previously, good managers have a certain feel for what is possible and what is required to make things possible. At the same time, member involvement is also an essential part of cooperation, and this requires transparency so that decisions will be realistic and productive.
One way of gauging member concerns is to undertake a survey that could include the following questions:
What types and levels of services do members want? The survey should list several alternatives, which can be ranked, and also leave room for items not on the managers list.
Responses to this question can be used to identify priorities and, most importantly, to calculate the costs of changes that members want and that are realistic. If members do not have realistic views, this is probably because their cooperative is a traditional one, in which member involvement in decision-making is only pro forma. Member education in the parameters and risks of the cooperatives business may be helpful here.
What would it cost members to implement the improvements that are most important to them? If the improvements involve the purchase of machinery, vehicles and other tangible assets, what are the useful lives of the equipment required, and how can they be paid for?
Would it be useful to adopt new financing practices, such as a base capital plan, redemption schedules for shares, and/or changes in the amounts and retention periods for patronage refunds, to achieve those goals?
How much are members willing to invest in the improvements that they would like to see? Various possibilities should be explored: greater patronage, increases in membership, purchase of shares, larger retentions from patronage refunds, sale of notes or other forms of debt, special fees, timing of payments, etc.
The important variables are the amounts and the lengths of time these additional resources will remain in the cooperative before having to be returned to members. Members will probably be most willing to provide longer-term resources when participation levels are high, spreading the burden and the responsibility.
What sort of returns could members reasonably expect from their investment in the improvements that they want to make? How could the finances of the cooperative be arranged to achieve these returns? This question has to be posed in at least two dimensions: how much? and when?
The second step might be to establish a committee to review survey results; use workshops to explore ideas and options and to develop a concept for the cooperative; communicate with members to move towards consensus; invite outside consultants and speakers to facilitate the development of realistic plans.
The responses provide a basis for business planning. They also engage members and, by showing what members come to see as possible, may create a cooperative spirit that opens more doors to progress.
In many cases, Northern cooperative movements or institutes may be in a position to provide advice and assistance. International cooperative organizations are also dedicated to facilitating activities that will strengthen cooperatives in developing countries and transition economies.
The final result should be agreement on a member investment strategy and action plan
The goals of managing capital are to ensure that:
a) sufficient liquidity is on hand to meet obligations falling due;
b) risk is controlled;
c) financial self-reliance is maintained; and
d) business goals are achieved.
Meeting these goals enables the cooperative to remain competitive in the most efficient way possible.
The type and source of capital is important because they determine the terms and conditions attached and require different mobilization incentives.
Institutional and member capital are the lowest risk, safest forms of funding and hence should be the starting point. A cooperatives institutional capital is perpetual (as long as the cooperative is in business) and can finance fixed assets, that is, long-term investments such as buildings and equipment with long lives.
Share capital is a relatively stable and long-term source of funds which turns over slowly as members invest and disinvest. These funds are suitable for long-term and medium-term investments such as vehicles and small machinery. The cost of share capital is low because of the cooperative practice of making low (or no) payments to members based on their shareholdings. It is also low risk since no collateral is required to secure members funds.
Internal funding may be insufficient or not available when it would be most useful. Short-term borrowings are useful for seasonal purposes. For example, a marketing society may take short-term seasonal loans from a bank to finance purchase of members harvests and running costs until the harvest is sold, at which time the loan is repaid. Short-term loans are normally less expensive than longer-term loans because their risk is generally lower - in the long run more things can go wrong than in the short run.
Good funding practice is normally based on timing and on the principle of matching sources and uses of funds.
Funds should be borrowed when they are most useful.
Loan amounts should be determined by the capacity to repay at loan maturity, assuming some adversity.
The projected return from the use of the funds should exceed the interest rates paid on loans.
Sources of funds for the repayment of loans, deferred payments and share redemption should be identified and quantified.
Risk as well as returns should govern all borrowing decisions.
However, longer-term loans may provide more flexibility to the borrower, depending on the terms and conditions attached to the loan. A long-term loan could help to finance a new building or piece of equipment. Equipment suppliers may also provide suppliers credit to a cooperative, with payments spread over a period shorter than the life of the equipment. The supplier is protected against risk because the equipment is pledged as collateral.
Businesses that are similar usually have similar financial structures. This creates peer groups that can be used to develop norms and baselines to give guidance in cooperative financial planning. One use of these norms or averages is to identify outliers, or businesses that deviate from the average to ascertain the characteristics of the most and least successful. It could be helpful for national cooperative federations to compile statistics of their members classified into various peer groups by product, size and age, for example.
However, several problems may arise in peer group analysis. For example, if most dairy cooperatives in an area are not doing well, the average is not a good guide for successfully structuring finances. Differences in bookkeeping practices may make it difficult to draw valid comparisons. Comparison across countries could be misleading because of different legal and accounting regimes and tax treatments.
While peer group analysis may offer some insights, it may be inappropriate for government authorities to specify limits or targets because different relatively successful cooperatives may take different approaches to their finances. (An exception is banking, which is quite rigorously regulated for reasons of consumer protection and public confidence.)
As stressed above, members of cooperatives perform two roles: as users/ suppliers, and as investors. Successful commercial cooperation seeks to create an optimal balance between these two roles. This quest is reflected in the innovative ways in which cooperatives obtain capital.
When excessive funds are accumulated, they may be used unwisely. For example, some cooperatives build unnecessarily large office or commercial buildings or hire superfluous staff.
Both excessive institutional capital and overindebtedness pose a threat to cooperatives.
Too much institutional capital
Institutional capital belongs to the cooperative collectively. Traditional cooperatives rarely accumulate too much institutional capital, except through donor subsidies, and New Generation Cooperatives are structured to avoid the problem. However, members of commercial cooperatives should be aware that if the amount of institutional capital becomes too large, the original purpose and ideals of the cooperative may be lost, as outlined below.
The Free Rider Problem described above explains why very high levels of institutional capital may lead to the exclusion of new members, which is contrary to the cooperative principle of openness. This may also lead to the use of noncommercial means of returning benefits to present members, such as making intentional losses through unrealistically low pricing for services, which milks the cooperative dry.
Another danger of too much institutional capital occurs when the ratio of institutional to member capital becomes too large. This makes the cooperative ripe for takeover or demutualization. Incentives for takeover arise when the economic or market value of the cooperative is much larger than the value of its members shares. The high value of the cooperative does not produce high returns to members since dividend payments on member shares are generally low and they have little opportunity to redeem their shares except by withdrawing from the cooperative. Even then, they are redeemable only at their original purchase price, which may be far below the value of the business. When a sufficient number of members become aware of this gap between the value of the business and the value of the cooperatives outstanding shares, they may want to obtain the full value of their investment. Demutualization becomes attractive.
Assume, for example, that a cooperative business has 10,000 shares outstanding with a fixed value of US$10 each. Assume also that a competitor would like to buy the cooperative business for US$500,000. The shares would theoretically be redeemable for US$100,000, but the purchaser would be willing to buy them for US$500,000 because that is what the cooperatives business is worth in the market. The tremendous demutualization gain of US$400,000 is a considerable business opportunity that would be hard for many members to refuse.
Commercial cooperatives have devised a number of innovative ways to maintain a proper portfolio balance of member share, institutional and debt capital. Innovations that provide greater returns to members often use methods that diverge from traditional cooperative practices and principles. One of these is to revalue shares periodically. But when this occurs and members still want to sell their shares, the amount of cash needed to redeem them is also greater on a per share basis. A highly successful cooperative with strong cash flow might be able to obtain a loan to buy these members out, but even then the gains from sale of the entire cooperative might be considerable. This exposes another weakness of cooperative capital, which is redeemable shares. Cooperatives have to recapitalize themselves continuously by mobilizing member capital for growth and to replace amounts paid out to members through patronage refunds and share redemptions.
Sale of the cooperative to a private investor is also attractive if it becomes top-heavy with older members who want to retire and redeem their shares for cash. However, cash for redeeming shares is not always readily available because most of the cooperatives assets are invested in plant and equipment. Sale of the cooperative, therefore, may become the only way to raise the cash to buy these members out.
Over-indebtedness and the importance of the gearing ratio
As a generalization, the more assets a reasonably successful cooperative owns and has fully paid for - buildings, equipment, stock (inventory) and financial reserves - the more others are willing to lend additional funds. But cooperatives should borrow with care, since accumulation of excessive debt can pose a serious threat to the cooperatives viability when loan interest and principal cannot be repaid as scheduled.
The greater the amount of the cooperatives institutional plus member capital, the higher the amount that can safely be borrowed from outside sources. The ratio of the cooperatives own funds to those that it borrows is called financial leverage, or gearing ratio.
The gearing ratio is a simple but partial indicator of the amount of risk involved in borrowing funds. Other things being equal, the higher the gearing ratio, the higher the risk that the cooperative could lose its assets in the event of inability to repay a loan. Box 6 gives an example of how the gearing ratio is calculated.
The gearing ratio and hence the level of risk involved in borrowing a given amount will vary according to the type of business a cooperative conducts. A consumer cooperative with a high level of turnover but relatively low investment in fixed assets (such as buildings and machinery) may be able to safely take on relatively high short-term debt in proportion to its total assets because its assets could be sold quickly. The same gearing ratio would represent a higher level of risk for an agro-processing society with relatively large investment in illiquid fixed assets.
Box 6: The gearing ratio explained
Gearing = funds borrowed ÷ (institutional and member capital plus funds borrowed) x 100
For example, a cooperative might have US$900 of assets and no debt. If it borrows US$900 from a bank, its total assets would be US$1 800, and its gearing ratio would be 50%.1 If on the other hand, the cooperative borrows only US$100, its total assets would be US$1 000 and its low gearing ratio of 10% indicates a much lower level of risk.2
The relatively high level of short-term debt that the consumer cooperative could command represents its higher turnover ratio. This ratio is the average level of inventory (stocks) divided into annual sales. Consumer cooperatives selling goods every day have more cycles per year than a grain cooperative that buys one harvest a year. This means that a consumer cooperative would be more liquid - its inventory (stocks) are closer to cash - than are the grain cooperatives. This implies less risk, other things being equal.
As noted, the gearing ratio is a partial indicator for at least two reasons.
Term structure of debt: Risk is created by mismatches in inward cash flow (including cash on hand) and the maturity of debt. The matching principle requires that these be managed so that the businesss operations are not interrupted. Coordination of this sort can be achieved entirely internally or by using new debt to retire old debt.
Seasonality: Agriculture is usually a seasonal activity. Seasonality creates special risks, as indicated by the lean season that affects many less developed agricultural societies. Food, money and other resources are typically in short supply during the period just before harvest.
Likewise for finance: a cooperative business has to have sufficient resources to survive the period in which it has the most debt. This usually occurs when liquidity is least. At this time of year the gearing ratio will typically be much higher than in the flush season when the cooperative has received payment for the sales of its members produce. Cooperative managers responsible for finance should base their budgeting and management strategies on the lean period when risks are highest.
 Liquidity is defined as
cash or assets easily convertible into cash.|
 Another, cautionary perspective on the gearing ratio is that cooperative shares, being redeemable, are also a form of debt. Highly commercial cooperatives may have redemption plans so that members can cash in or exit in an orderly manner. The gearing ratio may therefore have to be adjusted by the amount of these obligations or by some reasonable estimate.