Before you buy, "stress test it"
by Gary Sipiorski
The author is the dairy development manager for Vita Plus of Madison, Wis. He is a member of the board of directors with Citizens State Bank of Loyal, Wis.
In 2011, dairy producers received the highest Class III average yearly milk price ever recorded at $18.37. The highest monthly milk price of $21.67 was tallied last August, and it was preceded by the second-highest monthly total, $21.39. One has to look back to July 2007 to find the third-best Class III of $21.38.
Dairy farmers weren't the only ones who received a high price for their product . . . grain producers, too, saw some all-time best paychecks. Granted, expenses ran high; however, there was still plenty of cash on hand with the expected gain in 2011's total farm income to be more than $7 billion over the previous year when all of the numbers are finally added up.
Profits and expenses are up
We have all heard the comment, "When farmers have money, they spend it." It is true that farmers help move the economy. As a result, machinery manufacturers have stayed busy, farm construction businesses are hiring workers, and land inflation continues. While profits are up, so are expenses. Based on these higher production costs, higher incomes are needed but not guaranteed.
Future profits are not guaranteed. We are coming off a year with record dairy exports. But future success is not guaranteed. There is uncertainty with European debt, and one never knows what is really happening in Asia, so stress testing new capital expenditures should trump emotion.
On the flip side, the Federal Reserve Bank's January statement stating it will keep interest rates at the present level until late in 2014 does send a signal to buy something. The Federal Reserve, in March 2012, has repeated their statement that interest rates would stay low until the end of 2014. All of agriculture, however, needs to be watchful that they are not lulled into thinking prices will never drop again.
Stress test purchases with at least a 25 percent lower milk price. Think that's unrealistic? Then remember 40 to 60 percent downturns have taken place in the last 20 years within agriculture. Specifically, here are the steps:
1. Stress test your balance sheet. What would it look like if cattle and land prices dropped by 25 percent? What would your net worth look like? Would your lender still be able to lend you money for an operating loan?
2. Stress test your cash flow. What would your income look like if milk dropped by 25 percent? Given current market conditions, there could be $2 to $4 in your milk check related to the export market. What if Europe has a recession and it spills over onto the Asian economy where much of our powder is shipped? Would they cut back on their purchases?
3. Stress test interest rates at 8 to 12 percent. Even though the Federal Reserve has made a multi-month statement on low interest rates, never say never.
4. Stress test your current equity or liquidity. How much cash do you keep on hand? At a recent dairy business meeting, it was suggested that dairy producers keep two months of milk checks in reserve. I know that it is ridiculous for many dairy producers to think about keeping that much cash in a money market. Just think what they could buy. How different would the stress level have been in 2009 if there had been one month of income parked in the checkbook?
5. Sit down to think about and work through income and expense changes on your dairy before making a major financial commitment. Work the numbers through before emotion takes over. Make sure you do not load up on a lot of monthly payments in good times only to find it difficult to make the payments in skinny times.
6. When assets are added to the dairy, ask yourself if each dollar invested can generate at least 70 cents of gross income each year after the initial purchase. Some accounting firms think even higher gross incomes should be expected.
7. Sit down with your family members and key employees to determine if they see purchases the same way you do.
8. Talk over your intended purchases with your financial consultant, accountant, and certainly your lender before adding to your debt. Bankers do not like surprises even though they have plenty of money to lend and generally want to say "yes."
Be able to ride the cycle
There have always been up-and-down prices in agriculture commodities. There are always risks and many opportunities. Be careful of the mind-set of a "new era" of now permanently higher commodity prices. Change and progress are good, but make sure you have your financial eyes wide open to the reality of what is possible and stress test your ideas first.
This article appears on page 384 of the May 25, 2012 issue of Hoard's Dairyman.