By Ken Bolton, University of Wisconsin Extension
The primary financial stressor facing the dairy industry during late 2008 and throughout 2009 was the challenge to pay the bills with less than adequate Cash Flow (CF). While related, CF and Profit are distinct and separate issues. It is possible to experience CF shortages while profitable and to generate sufficient CF when profit is lacking. The needed level of CF for a particular business depends on levels of income generated, expense incurred and whether or not the farm manager can sleep at night.
Liquidity is the financial ability to pay the bills as they come due without unduly disrupting business operations. The action which most often disrupts business operations is the selling of production assets to generate cash to pay for short term production inputs.
Liquidity is typically measured in two terms; Current Ratio and Working Capital. Current Ratio (CR) is the relationship between cash plus near cash items and, bills plus operating debt plus the annual portion due on long term debt within the fiscal (financial) year. Near cash items include feed and other products of production in inventory which hasn’t yet been sold or fed to produce milk and animals which will be sold. Working Capital (WC) is the dollar value difference between Current Assets and Current Liabilities. WC is a snapshot in time representing the sum effect of CF up to that specific point.
WC may be compared to a peaceful looking static bee hive. Looks can be deceiving. Within and underlying this single dollar value is a literal colony of activity throughout the fiscal year that is far from static. Preceding this single value snapshot is each of the varying incomes from day to day and month to month. Additionally are all of the ebbs and flows in input costs including the current portion of debt due within the same fiscal period. In contrast to the snapshot in time single value of WC, CF is the difference between each of the variable incomes and expenses up to the time WC is calculated. Both CF and WC are indicators of the Liquidity of the business.
WC and CR are indicated on the Balance Sheet and CF on the Statement of Cash Flows (CF). Profitability is reflected in the Farm Earnings (FE) Statement.
All three are related and are thus referred to as "Integrated" financial statements. The CF Statement tracks all sources of cash including operating, investing and financing. The FE Statement accounts for all sources of cash incomes and expenses from production operations including the differences between those held in inventory (current ) and livestock (Intermediate) from one year to the next plus changes in prepaid and accounts receivables minus depreciation.
Two additional measures of Liquidity often considered in non-agricultural businesses are the relationships between WC and revenue as well as WC and production expenses. We address these ratios as well as those mentioned above in the new "Planning for the Next Swing in Milk Price" program. You may find them instructive as they report the percentage WC represents of total revenue and of production expenses.
The Balance Sheet is the source for determining Solvency, the ability to pay off debt from the absolute liquidation of business assets. CF affects FE which effects Liquidity which effects Solvency. Each must be considered in projecting business performance, typically in the form of an annual business plan.
The integrated financial statements detailed above along with an annual Business Plan direct you to answering the "Will I be able to pay the bills" question so often asked. According to industry sources lenders are increasingly requiring the above statements and an annual plan as well as monthly comparisons between the plan and actual performance. Even without an outside requirement, managers who have and use these reports in management decisions have established a competitive advance in the dairy industry for themselves. Is it time for you to take advantage of the same?