When considering the acquisition of a long-term asset, a farmer is analyzing a capital investment. Dairy farms have multiple and diverse situations in which a capital investment needs to be evaluated. Some examples include the building of a new barn, the upgrade of a milking parlor, the purchase of a new mixer, the installation of a new manure storage system, the migration to automatic calf-feeders, or the purchase of a new tractor. After reading this short list, the reader might appreciate that dairy farmers are regular investors.
Gut feeling or financial analysis?
Different approaches exist when deciding whether a capital investment should be pursued. A common attitude is “the gut feeling approach.” This tactic has no method whatsoever and relies heavily on emotions. For example, the labor situation on a dairy farm can be so problematic that a given farmer might feel they have two options: quit the dairy activity or migrate toward automatic milking systems. The bad side of the gut feeling approach is that the decision can end up generating some financial stress due to the lack of a financial analysis.
To avoid that stress, a financial analysis is useful, but first, there are some steps to walk through. My recommendation is to start by knowing where the farm stands financially.
What is the debt status or solvency? If debt is too high, can you afford adding to the debt? Also, what is the liquidity of the farm? Are there any rapidly available assets to support the investment in the short term? Is there any cash availability for a down payment?
The next step is to evaluate the current production system. What is the cost of production? Is the farm making money? If not, why? Are there any inefficiencies that can be changed without making a major investment? In this line, it is extremely important to visualize whether the new investment will correct those inefficiencies or not. Keep in mind that the investment might not be the right choice to solve specific issues.
Once you answer these questions, then it is time to perform a strict financial analysis. For this, evaluate options and distinguish what is needed from what is wanted. I always use the example of switching to automatic milking systems. Typically, a retrofit is the desired (cheaper) option. However, a new barn might be the needed option.
Then, visualize the impact of the investment and build a cash flow projection. Here, you will need to make several assumptions, but keep in mind that wrong assumptions might lead you to wrong decisions. Finally, apply the time value of money to the cash flow and determine the present value of the investment. If the present value is close to the total investment, then bring your gut feeling back into the game. Maybe you can co-exist with some “small red numbers.” However, if the present value of the investment is way below the investment, then it might be wise to put the investment on standby or find alternatives. After all, you will sleep better after such a decision.