With today’s margins, what should a dairy focus on to build the liquidity and working capital it needs?
By Steve Bodart, AgStar Financial Services
With the recent improvement in a typical dairy’s margin over feed cost, most dairies are starting to see some improvement in their cash flow. This improvement allows dairy producers to catch up on any bills that may not have been current, start doing some deferred maintenance and — possibly — look at making some capital purchases. The strong current margins are causing some producers to think about what is next for their operation. While it is important for a successful business to look at all these factors, it is also important for a dairy to focus on rebuilding working capital during these times.
Working capital is one of the best measures of an operation’s ability to weather a storm. Working capital is an operation’s first line of defense and a shock absorber against a price or yield decline. The stronger the working capital of an operation, the longer it can withstand poor or negative margins without being forced to change its cost structure. Working capital is defined as current assets (cash or items that are normally converted to cash during the course of a business year) minus current liabilities (financial obligations that are due and payable within the next year). In other words, it’s the owner equity in the current portion of your financial statement.
It is critical for dairy operations to understand how their working capital stacks up with other dairy operations within the industry. As a general rule, I like to see the operations that I work with have working capital that is equal to their cost of production for two months. So if their operation has milk sales of 25,000 pounds/cow annually and their cost of production is $17.50/cwt, a target for their working capital would be $730/cow.
Building and retaining adequate working capital sometimes creates a conflict for producers, however. Producers often feel that investing the cash into assets of the business will improve their profitability. While this is generally true, a lack of working capital can have a tremendous negative effect on the business during the volatile times of low or negative margins. A lack of working capital can result in peaked-out operating lines, past due open accounts and no ability to take advantage of opportunities as they come along. Without adequate working capital, an operation has limited liquidity and the situation puts a great deal of stress on the people managing the finances for the dairy.
With today’s margins, what should a dairy be focusing on in order to build the liquidity and working capital it needs? I would suggest they focus in on making sure all of their vendors are paid current first. In doing this, it is also important to make sure that your hedge line with your lender is reconciled and kept in line with the current outstanding positions that you have.
The second place that extra cash should be used is to take care of your revolving operating line and ensure that this loan has been paid down so that you have availability of credit in times when margins do become tighter again. The third area to make additional payment on would be on revolving capital lines and revolving cattle lines. This payment will not directly improve your working capital position but does provide you the ability to access credit for the purchase of capital items or replacement cattle.
Remember the milk market is a very volatile commodity and working capital is necessary to weather those turbulent times. As the old saying goes, "the cure to high milk prices is high milk prices." Make sure your dairy is positioned to handle the difficult times and take advantage when opportunity arises.
Steve Bodart is a Principal Business Consultant for the Dairy Industry at AgStar Financial Services.
For more insights and regular dairy industry blog posts, check out AgStaredge.com.