Manage Risk in a Volatile World
Oct 07, 2012
It comes as little surprise that price swings and volatility are increasing for dairy producers. But the degree of that increase over the past two decades is stunning.
Chris Wolf, a dairy farm management specialist with Michigan State University, presented some recent analysis of those changes at an Education Seminar at World Dairy Expo on Friday.
In the 1990s, the coefficient of variation—which economists use to measure volatility—stood at 0.10 for all-milk price, 0.24 for corn, 0.15 for soybeans and 0.21 for hay. Fast forward a decade, and those coefficients double: 0.20 for milk prices, 0.47 for corn, 0.38 for soybeans and 0.35 for hay.
And with greater variation and volatility comes greater risk, as virtually every dairy producer found out this summer and fall as prices sky-rocketed. "The volatility in both milk and feed prices means that changes in the working capital on farms is also volatile," says Wolf.
Wolf recommends producers perform solvency stress testing on their finances to determine how prepared they are to withstand these price swings and the resulting pressure on cash flow and liquidity. He recommends that you look back and calculate cash flows for the past three to five years to get a sense of cash flow needs for your operation. Then do a forward looking cash flow with the most likely milk and feed prices, and also examine "worst-case" scenarios. That should give you some sense of how large potential losses could be.
Once you have those numbers, you can better assess what type of risk management you need to do, whether it’s self-insurance through reliance on savings and equity, forward pricing or hedging milk and feed.
Most economists say you need a debt-to-asset ratio less than 0.60. Liquidity—current assets divided by current liabilities—should be at least 2:1. "Higher is better. The question now is whether 2:1 is high enough," says Wolf.