February 1, 2017

Cash is King, When You Have It

 |  By: Curt Covington

It’s not like dairy producers are printing money at the moment. Those who have been around this industry long enough know it’s just a matter of time before the market turns and dairies start being profitable again. Along with profits comes the prospects of having to decide what to do with your excess cash.

Before we decide what should be done with excess cash, we first need to lay the ground work for what excess cash is. Bankers and borrowers alike have differing views of what excess cash really is. So, let me give you my very simple view: Excess cash is defined as cash remaining at the end of the month after all recurring operating expenses, taxes due, reasonable family living expenses are paid, recurring capital maintenance costs are covered, and all regular interest and term loan payments are paid. Corporate America defines this as free cash flow.

Free cash flow, is the cash that remains for discretionary purposes. I use the word discretionary because it is at the borrower’s discretion what the excess cash will be used for. Experts in the “main street” business world tell you to either store it, pull it, buy inventory, buy another business or spread the wealth among your most loyal employees. Before the dairy industry crash of 2009, cash along with borrowed money was often times directed to expansion projects—more cows, more free stalls, more modernization. Put simply, dairies and their bankers were often times in the asset building mode. This is not necessarily a bad thing. But, when coupled with market volatility, timing is everything.

So, what should you do with that excess cash? There is a short and long answer to this question. In the short run, excess cash should be used to pay down herd and feed debt. It doesn’t do any good to look at the cash sitting in a barley interest bearing account. Reduce your interest cost, build a store of working capital in your herd and feed, then decide what to do next. Unless it is the only debt you have, it rarely makes sense to prepay long-term real estate and equipment debt. Prepayment of term debt ties up your cash through the maturity of the loan. Don’t forget, you operate in a volatile industry and the first line of defense against volatility is having access to your working capital when you need it most.

From a long-term perspective, you must decide how much of your working capital can be allocated to expansion and deferred maintenance or asset purchases. We might call this excess working capital, that is, the amount of herd and feed equity you possess in excess of some required amount of working capital. There is no magical formula here and it depends where we are in the dairy profit cycle. If a dairy during a market downturn has a negative free cash flow of $100,000 a month and it is expected that conditions will persist for the next six months, then that operator needs to have at least $600,000 of lendable herd and feed equity to carry them through.

In the end, it’s all about planning. Plan your cash uses during the profitable times in preparation for the tough times that will surely come again.

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