Accounting for profits: Where do we go from here?

By Bob Matlick

As we deal with the effects of the deep recession the world has experienced over the past 20 months, the term deleveraging, being bantered about throughout the financial and business world, comes to mind.  In researching the term deleverage, Investopedia says, “[c]ompanies will often take on excessive amounts of debt to initiate growth. However, using leverage substantially increases the riskiness of the company. If leverage does not further growth as planned, the risk can become too much for the company to bear…”

We are all aware that 2009 was one of the worst years in the dairy industry as far as profitability. The average dairy operation lost $600-$900 per cow for the period ending Dec. 31, 2009, but it appears the losses slowed somewhat in the first quarter of 2010. However, the return to profitability in the industry has not occurred, and it may not be until the 3rd quarter of 2010 before any sustained profitability will occur in the overall dairy industry.

A majority of the dairy producers throughout the United States have utilized debt to fund the aforementioned losses and will attempt to do so until the industry returns to profitability. The debt incurred over the past year and a half was not for growth; rather it was utilized to stay in business and fund losses. While it is impossible to ascertain the amount of debt growth within the industry in the last 24 months, I believe it is safe to assume that is has grown dramatically. Most financial institutions and vendors continued to extend credit/debt to the industry with a clouded crystal ball that indicated “it just had to get better.” The bottom line is that it didn’t get better and we now find an industry that is highly leveraged (excessive debt per cow or income generating unit) and there is a call for quick deleveraging from its financial institutions and creditors. The call for deleveraging most likely stems from the above-referenced definition that stated “the risk (of high leverage) can become too much for the company to bear.” This means that liquidation of some or all assets becomes the only way to manage the high debt levels and reduce debt, or bottom line, exiting the business. It also means that as the debt has grown (to fund losses as opposed to growth), so has the risk of staying in business.

I believe the industry has now reached a point where credit institutions and vendors are demanding clients deleverage to reduce risk. I think they may be asking too much of the industry in an abbreviated time frame. Most conversations I have with lenders center on the question of how quickly can the operation return to “normal” or conforming loan to value ratios.  For example, lenders are pushing for dairies to conform to a 75% loan to cattle value. This leverage has also been exacerbated by the falling cattle values that have created higher loan to value ratios. If a lender requires a deleveraging process at too quick of a pace, the business will fail to meet its deleveraging obligations and make the situation worse.

So, what can a producer do to begin to deleverage and reduce risk?  My first answer would be to communicate. Speak openly and truthfully with your creditors including your bank(s). Secondly, it is important to have detailed cash flows for the upcoming 6 to 12 months.  I am encouraging producers to build semi-monthly cash flow scenarios where cash shortfalls and windfalls can be determined.  This is a time consuming and tedious task. However, once the process is developed and implemented, it gives the producer a clear picture of what time frame the cash will be generated and utilized. The cash flow scenarios are somewhat different from a projection in that they account for the payment of scheduled debt, payment on past due trade debt, and account for cattle, heifer, and weather related variations. With cash flow information, an owner can then interact and discuss with creditors their deleveraging plan of action and begin to reduce risk. I also encourage producers to track their actual performance to the projected performance and change course when needed. This exercise enables the producer to understand what the variances are and make the appropriate adjustments going forward.

Utilizing projected cash flows and keeping them updated on a consistent basis also allows for margin management and the use of forward contracting or floor price protection. With the use of margin management tools, cash flow projections become more predictable and begins to give certainty to the deleveraging process.

FYI

Bob Matlick, CPA, is a partner at Frazer Frost, LLP, in Visalia, Calif. Contact him by e-mail at: bmatlick@frazrfrost.com or call, 559-732-7140.


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