Financial risk and resiliency are topics on everyone’s mind. These issues leap into the forefront during tax season. Everyone must file taxes, not everyone pays the same interest rate with their respective lending institution.
“Previous research suggests interest rates could vary a percent and a half between a high- and low-risk farm,” explained Cornell University’s Chris Wolf on the University of Missouri’s Dairy Science Digest podcast. “The riskier you are, the more likely they are to charge you a higher rate,” continued the E. V. Baker Professor of Agricultural Economics.
Wolf went on to explain that a risk premium ultimately protects the bank. That protection for the bank also makes borrowing more costly for dairy farmers, especially on those long-term notes.
Since dairying is capital intensive, maintaining strong relationships with your lender and factoring in your operation’s financial data will help owners navigate through all the different market conditions. Specifically, using financial thresholds and benchmarking against similar farms will help develop financial resiliency over time. Understanding what lenders assess when determining access to capital, a farm’s risk holds potential to dramatically impact the cost of borrowing.
Wolf shared that there are multiple dimensions related to how the farm is performing financially, and therefore, the financial risk or resiliency. A common tendency is to look at profitability for performance. In general, that can be a good metric, but it doesn’t tell the whole story.
Three ‘biggies’ all farm owners should know are:
- Profitability – Can you generate return? – especially to the unpaid labor management, which is so common on dairy farms
- Solvency – the extent to which the asset value exceeds the underlying liability
- Liquidity – availability to pay your bills as they come due
Profit is those good years
Another easy-to-benchmark metric is the rate of return on assets (ROA). This normalizes the financial data, regardless of farm size, to allow for the comparison across other operations. The 10-year average reported for the farms researched was 5% to 6%, with quite a lot of volatility. For example, 2011, 2014, and 2022 were classified as “good years,” with 2014 topping off at 12.7%, while some years the ROA landed near zero or negative. This indicates dairy’s “boom or bust cycle.”
Wolf warned, “You better make the profit on the good years and manage your liquidity and debt on the bad years.”
Take time to track these indices over time to reveal where the profit is coming from and whether there’s a solvency, liquidity, or cash flow issue. This will guide your management choices to “plug the hole” more rapidly, as Wolf pointed out.
Will there be a next generation?
Net farm income or profitability is the most important assessment before bringing the next generation back home.
“The business must be set up to have enough return to support the incoming family,” he said. When Wolf interviewed farms five years post-expansion, “the single biggest regret was that they hadn’t expanded more when they did it.” As the young family takes on more debt to support the farm, expansion may be available to provide the return needed to support the next generation.
To read more on this topic, read the Journal of Dairy Science article, “Financial risk and resiliency on US dairy farms: Measures, thresholds, and management implications." Also, go to any of your favorite podcast platforms to listen to the full University of Missouri Extension’s Dairy Science Digest podcast.