By Robert Burroughs
Three years ago, I was approaching 50 years of age, was horribly out of shape and overweight, and I knew that with my family’s history of heart problems, I could end up in a pine box in a very short period of time if I didn’t take some action to change my “situation.”
To make a long story short, in the last three years I have lost 55 pounds, made regular workouts a part of my lifestyle, changed my eating habits and as a result now am able to go backpacking in the Sierra Nevada, have climbed a 14,000 foot peak in Colorado, and have seen my blood tests reveal excellent heart health. For a 52 year old, I am fairly physically fit.
You’re probably thinking, “So what? What has that got to do with the dairy business in 2011?” Well, just like individuals need to assess their physical fitness, each dairy business needs to evaluate its own fiscal fitness, and then make a plan to get in better fiscal shape.
Getting in shape
So let’s take a look at the process of getting in shape. In my personal journey toward physical fitness, my first concern was cardio-vascular health, and in a business that equates to profitability.
Profits are very much like a healthy heart and lungs, because as long as the business is making money, it will be able to survive quite a long time, even if it has other problems. Keep in mind that because the dairy business is highly cyclical, we don’t look at only one year at a time, but at a three to five year period.
If your dairy has not shown fairly significant average profits over the last five years, then just like I started on a controlled diet and training on a stair-climber to lose weight and get my cardio-vascular system in shape, you need to make the changes necessary to become profitable.
Most dairymen have already “gone on a diet” so to speak, and have done all they can think of to cut their expenses and make their operation more efficient. While that doesn’t mean that there aren’t ways to do more with less, I am not going to spend a lot time in this article talking about how to cut costs. We are going to talk about the next phase of fiscal fitness.
Shaping up the balance sheet
As important as profitability is, we also need to understand how to shape up your balance sheet. You can have good profitability but if you don’t use it correctly, you can still end up with a bad balance sheet. Just like I started lifting weights and doing strength training workouts in order to increase muscle mass and re-shape my body, each dairy business has to think about the “shape” of their balance sheet. Does it have the right proportions, and is it in condition to handle whatever stresses may come?
We all know what a great body looks like, but what does it take to have a well proportioned balance sheet? The most important measurement may be overall debt to equity, which measures how many dollars of debt are serviced by each dollar of equity? But the measurement I want to address here is the current ratio and the related concept of working capital.
The current ratio is calculated by dividing current assets by current liabilities, and working capital is the difference between the two. Current assets consist of cash, receivables, feed inventories, investment in growing crops, and prepaid expenses. Current liabilities are made up of accounts payable for feed and other trade expenses, accrued interest and other accrued expenses, and feed loans or other loans due within one year.
You would like your current ratio to be at least 1.25 (although some lenders these days want it to be 1.5 or higher). A current ratio of 1.5 means you have $150 of current assets for every $100 of current liabilities. The higher the ratio, the more working capital you have, and the better you will be able to handle times when cash flow is negative.
The losses that everyone in the dairy business incurred in 2009 put a huge dent in everyone’s working capital, and although 2010 was much better, it did not go very far toward replacing that lost working capital. We are seeing many, many clients with negative working capital on their financial statements, and that can be very problematic for their lenders.
How do you improve a bad current ratio? In the first half of 2011, dairymen should see positive cash flows, but if you use that cash to pay down long term loans, such as cow loans or real estate loans, or if you use the cash to build more freestall barns or buy more cows, you will not improve your fiscal attractiveness. Those dairies with low working capital need to take advantage of the current high milk prices and the resulting cash flow and use it to pay down old payables or feed loans. You also may be able to restructure your balance sheet, by paying off short term loans with long term borrowing.
If you have significant equity in cows or real estate, it may be possible to borrow against them to reduce your short term debt. Also, if you have any long term assets, such as notes receivable or other investments, which are not generating significant returns, you might consider liquidating them and using the proceeds to pay off short term debt. Be careful with this, as you may trigger tax liabilities in the process, so make sure you talk to your accountant before you make this kind of move.
Every dairyman needs to know
Fiscal fitness is imperative in these times of roller coaster milk prices and skyrocketing feed costs. Every dairyman needs to know what kind of shape his balance sheet is in, and how to make it better. The quickest way to shape up is to take advantage of these periods of positive cash flows to pay down payables and feed loans as rapidly as possible. Investments in long term assets should be carefully thought-out and financed appropriately, so the current ratio is not negatively impacted. At the risk of over simplification, a balance sheet looks best when it is heavy on current assets, light on current liabilities and heavy on long term debt and equity.
Robert Burroughs, CPA, and partner in Modesto, Calif., with Genske, Mulder & Co., LLP, a certified public accounting firm representing clients who produce 12% of the nation’s milk in 29 states. He can be reached at 209-523-3573 or firstname.lastname@example.org.