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Using rate of return triggers to help protect your dairy’s net worth

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By Tom McCormick

 

Market volatility can and has destroyed equity. Securing a favorable profit margin covering inputs and capital expenses will protect and grow the farm’s equity.  

 

A key objective for any business is to protect and grow its net worth for its owners. Whether it’s a Fortune 500 company or a dairy farm, the financial objectives are similar. Also common is the challenge many businesses face in determining a trigger level to execute hedges or forward contracts. 

For dairy business owners/managers, risk management is practiced daily in forms other than forward contracting. Weather forecasts are studied before a manager pours the first cup of coffee in the morning. Rations are formulated with risk avoidance built in. Animal genetics are studied to help shape a breeding program that will sustain or improve traits conducive to profitable milk production. 

Yet many managers hesitate when it comes to removing risk from the business’ income statement (profit/loss) and balance sheet (net worth/equity) based on the price paid for inputs or received for milk.

Market volatility can and has destroyed equity. Conversely, securing a favorable profit margin at predetermined rates of return (hurdle rates) that cover inputs (feed, labor, repairs) and capital expenses (interest, depreciation, taxes and amortization) will protect and grow the farm’s equity.  

A farm’s equity position is arguably its most important financial benchmark. Owners spend their entire lives protecting and growing their farm’s equity. Without it, farm expansion, transition or the owner’s retirement is severely compromised. 

Like all other risk management tools used on the farm, a well-planned hedging or forward contracting strategy tied to the farm’s cost of production and predetermined hurdle rates can deliver the equity growth necessary to achieve financial goals.

Table 1 is a hypothetical example of how higher volatility increases risk and damages net worth growth. The table shows how high income volatility – driven by unstable milk and feed prices – can result in lower long-run volatility in net worth. Planning your hedging or forward contracting strategy around a pre-determined hurdle rate, while covering your cost of production, can lead to more consistent long-term growth in the dairy’s net worth. 

Farm II did not experience losses that Farm I did in year three. Farm I had to make up a $26,000 shortfall before it could reestablish equity growth. In general, managing risk means sacrificing the possibility of higher market prices in favor of long-range equity growth. 

The goal instead becomes generating a sustainable return over the long term by locking in a margin that grows the dairy’s net worth. Lower volatility results in higher dollar returns because of the avoidance of low milk prices and/or higher feed costs that lead to unprofitable years. 

Anchor your dairy’s hedging and forward contracting strategy to its cost of production. Set gross margin hurdle rates that protect and grow the dairy’s net worth. This approach helps reduce the uncertainty and emotion of when to hedge. A hedging decision is meant to be based on the farm’s predetermined profit objectives, not by trying to speculate when the highs are in.

 

Tom McCormick is vice president of DFA Risk Management, which offers customized risk management programs to aid producers in managing dairy risk. For more information, phone: 877-424-3343 or visit www.dfariskmanagement.com.

 
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