Time To Replenish Working Capital
As milk prices continue to (hopefully) recover this summer and fall, now is the time to start thinking about replenishing your working capital.
“After the last couple of years, I don’t know if you can have too much working capital,” says Matt Lange, a dairy consultant with Compeer Financial.
“Building a strong cash position is critical not only for downturns in the market and managing potential negative margins, but allows you to take advantage of opportunities to acquire new assets, expand and undertake other changes you may want to make,” he says.
The old rules still apply though, he and Dave Kohl, an emeritus economist with Virginia Tech University, say. Shoot for at least $400 of working capital per cow—$600 is even better.
“I also like to divide working capital into annual expenses,” Kohl adds. “Once it’s above 25 to 33%, you’re pretty strong. But if the ratio starts getting less than 10% of your expenses, you’re going to have to be very careful that you don’t burn through your secondary reserve.”
That’s particularly true if you refinance to extend loans in order to lower monthly payments, he says. Once you do that, your margin for error becomes less because you have less equity in cattle, buildings and land to fall back on if you continue to have cash flow problems.
See the table below for calculating working capital. As milk prices and margins improve, re-building working capital and cash reserves should be done systematically. Here’s the order Lange suggests:
• First, payables should be brought back to 30 days net to avoid late fees and interest payments.
• Second, pay down operating loans and revolving lines of credit so that you again have the credit available should you need it for repairs, unexpected expenses or new opportunities that might arise.
• Third, make pre-payments if you can at the end of the year to take advantage of any discounts that might be available and to reduce tax liabilities on income and profits this year.
• Fourth, consider using extra cash to catch up on deferred maintenance and capital expenses.
This last point is key. Critically look at the items you replace. After four or five years of limping by, you may have little choice about replacing a skid steer you use daily to scrape manure. “But should we be replacing other equipment, like a forage chopper?” says Lange. “Can a custom operator do this work for you and do it cheaper?”
Or, a used chopper might be a better option than new. In any event, it’s important to go through the exercise of carefully analyzing any new equipment purchase, says Lange. Doing so can also put you in a better position with your lender to show whether or not the new piece of equipment is warranted, and what impact it will have on both productivity and the balance sheet.
Kohl also strongly recommends dairy farmers calculate their burn rate. This is done by dividing working capital by the amount of monthly expenses that must be paid. That will tell you, in a worst-case scenario, how many months or years your business can remain viable.
“We’re in a period of extreme volatility, and we’re just a trade deal or tweet or weather event away from markets reacting strongly one way or the other,” says Kohl.
Knowing both your level of working capital and your burn rate give you a much better idea of your farm’s near-term financial condition and viability, he says.
Lange also urges dairy farmers to use available management tools to mitigate market risk. “Whether through the Dairy Margin Coverage program, the Dairy Revenue Protection program, options and forward contracts, producers have very little excuse to not act on price swings that could be to their farm’s advantage,” he says.
Finally, he urges producers to focus on margins when making decisions. “Sometimes we need to realize that reducing a cost adds more risk to a business’ ability to perform and maintain profitable margins,” he says. “Cost control is certainly important, but it is essential to realize there is usually an offset on the revenue side.”
Table. Calculating working capital per cow.
Milk receivables 565,000
Feed/crop inventory 1,752,500
Value of hedge accounts 68,900
Total current assets $2,496,400
Operating loan balance $280,000
Accounts payable 600,000
Current portion of principal payments (12 mon) 520,000
Total current liabilities $1,400,000
Working capital (current assets less current liabilities)$1,096,400
Average total number of cows 2,665
Working capital per cow $411
Table source: Compeer Financial