Financial and management strategies in the economic reset
Dairy producers and lenders need to be working side by side as the world churns through the current economic reset, global slowdown and upheavals in political systems.
'It requires a team effort to do this,' Dr. David Kohl, professor emeritus of agriculture and applied economics at Virginia Tech, said during the final segment of 'Position Your Dairy For Economic Success,' a World Class Webinar sponsored by Professional Dairy Producers of Wisconsin.
Kohl expects more instability, more political dysfunction and major restructuring of the economy. 'You talk about volatility. We have seen nothing yet and that, of course, is going to play into financial and management strategies of our farm businesses,' he said.
The good news is interest rates are expected to stay flat, oil prices are beneficial and good dairy managers are already making cost adjustments.
'We're seeing lots of refinancing, lots of cost restructuring,' Kohl said. 'There's good news, but the somber news is we're probably not going back to that robust, growing global economy, or even U.S. economy, unless we have a major shock.'
Advice for producers
Kohl advised dairy producers not to go to their lender just requesting money. 'Go with a business and financial plan. This is very critical,' he stressed.
Be proactive, rather than reactive, when working with the lender, and keep open lines of communication on financial and management problems and issues. 'This (communication) is one of the big issues right now,' he said.
Kohl firmly believes in using variance analysis to monitor the dairy business. It is one of the best management tools available and, done monthly, enhances communication, battles complacency and helps the dairy take corrective action immediately.
Dairy producers need to set goals for the short (under one year) and long (three to five years) run. They need to have an up-to-date balance sheet, projected cash flow, list corrective actions with SMART (sustainable, measurable, attainable, realistic, timely) goals, review the plan with an adviser and make sure they're using a lender who understands dairy.
Kohl said high turnover in personnel is changing the financial industry and not many incoming lenders have a background in agriculture or knowledge of the dairy business industry. 'Institutional memory is going very quickly,' he shared, noting half of lenders have never faced a downturn. 'This whole new set of lenders will change the paradigm.'
In addition, regulators and examiners who were closely monitoring the energy fields are now shifting to agriculture, making it critical for dairy producers to have up-to-date financials. Expect lenders to start monitoring dairies — checking cattle numbers, checking machinery serial numbers — because regulators are starting to demand it, he said.
Taking an objective look at negative margins
Kohl provided a 10 question screening guide for negative margins that allow an objective look at the financial and management sides of a dairy business. 'I like to have lenders and producers go through these. If anything, it will open up conversation,' he explained.
·Has the dairy business been profitable above interest rates and the rate of inflation?
·Has it shown growth of balance sheet which is earned (vs. appreciated) net worth?
·Has it built and protected working capital in the positive cycle?
·Has it been able to cut living expenses if needed?
·Is it willing to sell unproductive assets?
·Has it followed and executed a marketing risk management program?
·Does it have the ability to cut 10 to 30 percent of costs?
·Can it shed unprofitable land. machinery, livestock or human assets, if necessary?
·Does it have a burn rate for working capital of 2.5 years or more?
If a dairy can answer yes to eight or more of the questions, Kohl believes it has a strong case for sustainability and refinancing. Between five and seven 'yes' answers shows a modest case for sustainability, while less than five 'yes' answers means the farm's sustainability is very questionable.
Kohl also offered a dashboard of key several ratios. 'These are going to be really important for monitoring,' he said. 'Everyone should sit down with their lender to come up with this dashboard.'
Lenders are looking for a debt to asset ratio of 50/50. 'Watch this one very, very closely,' Kohl said. 'Generally speaking, when you're debt to asset ratio goes above 50 percent, that puts you in the yellow zone. You're really going to have to step it up in management,' Kohl said.
That means being a real good cost control manager, have modest family living and properly structured debt and, probably, curtail growth plans, he explained.
Another ration is what percentage of revenue or expenses is working capital, meaning how much money can a farm come up with to meet expenses.
One respected dairy producer, for instance, aims to keep three months of expenses available, largely in cash. 'He says as farms get larger, the risk of goof-ups and failures increases dramatically and he has to, basically, insure himself on working capital,' Kohl observed.
All lenders will be looking at a farm's coverage ratio, which is net income plus non-farm income, interest and depreciation minus living expenses. 'It gives your repayment ability,' Kohl said, noting a lot of lenders are going to demand a covenant of 125 or, at minimum, 110 percent.%.
Besides the farm's burn rate, know its debt/EBITA ratio. The ballpark is less than 3.5/1, Kohl said, while 6/1 or 7/1 and above is critical territory.
Keeping it in perspective
It's important for dairy producers to keep their perspective when working through tight or negative margins.
Use an advisory team, Kohl advised, and deduce whether it is the economic cycle that created the issue or is it a management issue. 'If it's the management side, we can have corrections,' he pointed out.
Celebrate the mini- victories as the farm moves through the economic reset, Kohl advised. Know the personalities of the people involved in the business, and consider bringing in spouses and partners by sharing pertinent information. Document with a paper trail and make sure each asset 'earns or turns' .
Don't forget the nonfinancial characteristics that can help a dairy farm thrive through the economic reset. Seek education, take corrective action and be willing to adjust budgets, Kohl advised.
Be willing to accept counsel and advice. 'I tell lenders to avoid know know-it-alls and victims,' Kohl shared.
In planning for 2016 and beyond, Kohl advised dairy producers to get business, family and personal goals for the long and short term down in writing.
Tie cash flow to the business, both projected and actual, and develop a personal living budget. 'It is critical to know how much you are taking out of the business,' he explained.
In Kohl's experience, good managers zero in on cost control and trying to measure both fixed and variable costs. 'They keep good financial records and records in general,' he said, 'and they spend a lot of time on it.'