Profit in the Details Know your burn rate

March 5, 2009 06:00 PM
Dan Little
*Extended comments are highlighted in blue.

With record-low milk prices and relatively high feed prices, dairy producers nationwide are facing a negative cash flow of historic proportions.

"Burn rate” is a term that is used by businesses to esti-mate the consumption of cash during a specific period of time. Negative cash flow is normal during startup or rapid expansion of a business.

However, prolonged negative cash flow can be devastating for any business—especially if the business lacks sufficient equity to finance the burn rate. Put simply: Burn rate = change in cash position / specified period of time.

The period of time can be days, weeks or months. But the important factor to know is your burn rate and how it relates to cash on hand or to working capital. This will help you to determine the time period that your operation can sustain the current negative cash flow.

If cash reserves or working capital dip too low, it may be necessary to restructure debt to shift cash from long-term equity to current assets in order to sustain the burn rate. Of course, restructuring may not always be possible for highly leveraged operations.

Cash costs. To estimate your burn rate, you will need to determine the projected cash income and cash expenses for your dairy. This calculation is different than calculating net income since we are only concerned about cash income and expenses. 

For example, in the case of feed inventory we would usually consider the cost of feed leaving inventory to get a clear picture of income over feed cost, or gross profit. However, when calculating burn rate you should only consider the monthly cost for the feed that will be purchased.

Obviously, silage and haylage inventories will need to be replenished at some point in the future. But the harvest and restock costs will be included in the burn rate of a future month. All other cash costs should be included in the monthly cash expenses. Your projection should assume that all suppliers are paid in full each month.

Accurate income projection. It is critical that your income projection is as accurate as possible when calculating the burn rate. While cash expenses may be fairly stable from month to month, cash milk income and livestock sales can vary widely due to management and market changes. This is also the area that usually has the greatest ability to decrease the burn rate.

For instance, a 1-lb. or 2-lb. increase in milk/cow, or a 25¢/cwt. increase in milk price, can have a significant impact on the burn rate. To calculate an accurate milk price, it is usually easiest to compare your previous mailbox milk price to the previous Class III milk price to determine your farm basis. Then add the farm basis to the Class III futures prices for upcoming months to estimate the value of milk to be sold.

Communicate with your banker. It can be easy to deny that a difficult cash flow situation exists. Nevertheless, do your best to meet the challenge head on by calculating your burn rate and communicating your projected cash scenario to your banker.
Often in short-term situations, paying the interest-only payments on loans will provide just enough working capital to get you through a period of poor cash flow.

However, your lender will need to know when you plan to resume full principal payments. Due to bank regulations, this does not ensure that the bank will be able to finance your negative cash flow. But such communication can dramatically reduce the anxiety that comes from not addressing the causes and solutions for a business's burning excess cash.

Bonus content:

Click here to download "Dairy Profit Analyzer," then click on RADAR.

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