Liquidity Is a Lifesaver

January 6, 2013 07:41 PM
Liquidity Is a Lifesaver

But just how much do you need?

Liquidity is something every business needs in order to maintain operations. But how much is enough?

When milk and feed prices were more stable (remember the ’80s and ’90s?), lenders often advised that $200 per cow in easily available cash was enough for cash flow. Today, that number has tripled—even quadrupled.

The reason is that the volatility—the price swings between market highs and lows—has doubled in the past two decades, says Chris Wolf, a dairy farm management specialist with Michigan State University.

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In the 1990s, the coefficient of variation—which economists use to measure volatility—stood at 0.10 for the 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.

With greater variation and volatility comes greater risk, as virtually every dairy producer found out this past summer and fall as prices skyrocketed. "The volatility in both milk and feed prices means that changes in the required working capital on farms are also volatile," Wolf says.

An examination of Michigan dairy farm records shows what can happen. At the beginning of 2009, for example, herds with 450 or more cows had a current ratio (current assets divided by current liabilities) of 1.42. (The recommended level is 2.0 to ensure sufficient cash flow.)

By year-end, the current ratio had dropped to 1.07. That means current assets were barely enough to cover current liabilities. Had prices not recovered in 2010, it’s likely many of these herds would not have had sufficient cash flow without borrowing heavily against equity.

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 also recommends that you look back and calculate cash flows for the past three to five years to get a sense of the 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—and what additional cash inflows might be required. 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 of 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," Wolf says.

The other problem is that if you borrow against equity to meet cash flow, your debt-to-asset ratio will also erode. The problem with such erosion is that lenders will charge higher interest rates at higher ratios. And at some point, they won’t offer to lend any more funds.

"Those farms with higher debt-to-asset ratios should pay more attention to liquidity and risk management in general, as they have a smaller margin of error," Wolf says.


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