One of the many challenges of understanding dairy financial statements, and dairy operations as a whole, is understanding how to handle the biological and seasonal fluctuations so prevalent in the industry.
Weather patterns, reproduction cycles and cull rates are only a few of the many frequently changing aspects in the industry that have historically made it difficult for lenders and producers to understand what drives dairy profitability.
As a result, many traditional financial metrics have proven ineffective and have often caused headaches for lenders, producers and consultants. EBITDA, or earnings before interest, taxes, depreciation and amortization, has often fallen into this group of financial metrics brushed aside by the dairy industry. I think this is a mistake.
Let me take a step back. While there are many other examples I could use, I want to draw your attention to just one aspect of a dairy operation that can cause a lot of confusion for producers and lenders: herd size and, more specifically, an operation’s heifer-to-cow ratio.
A traditional financial statement does not tell the whole story of the impact a heifer program has on a dairy. Heifer-raising costs are capitalized on traditional financial statements, meaning they don’t impact the bottom line directly.
It is difficult to evaluate the impact of a growing heifer program on the operation’s profitability until the heifers freshen, transfer to the mature herd and start to be depreciated. To evaluate the impact of these costs and understand the immediate impact of improved reproduction, right-sized heifer raising and improved culling strategies, the dairy industry needs a decision-making tool that goes beyond the financial statement. EBITDA might just be that tool.
EBITDA calculations have been used extensively across many different industries to evaluate the cash flow, profit and operational potential of a company in normalized or “true” scenarios. In other words, EBITDA allows the financial statement user to evaluate how well they can expect an operation to perform and how much cash flow that operation will generate in a normal or stabilized period.
Why is this important for the dairy industry? While most dairy operations have the similar main goals – consistent reproduction cycles, maximum production and minimal feed costs, for example – there are many factors which can skew the presentation of a financial statement.
For example, a brand-new dairy may produce milk very efficiently, but the financial statement may show less profit than hoped for due to high depreciation expenses and increased loss on sale of cows. While these two items are certainly aspects of a dairy’s profitability, they generally are not useful for decision-making and can be distracting when evaluating operations.
This is where EBITDA or, as we will discuss later, adjusted EBITDA calculations can be extremely useful. By eliminating the impact of debt obligations, taxes, depreciation and amortization, we can better understand how the brand-new dairy referenced above compares to the older dairy down the road.
In order to consider EBITDA as a decision-making tool, you must start with a high-quality, well-prepared financial statement. It is essential to be able to trust and feel confident in the information presented. Once you receive your statement, calculating EBITDA is as simple as following E.B.I.T.D.A.
Earnings
Before
(+) Interest
(+) Taxes
(+) Depreciation
(+) Amortization
E ‘Earnings’ – Income or loss from operations
One common mistake in calculating EBITDA is always using the final net income or net loss from the income statement as earnings. For our purposes of evaluating the core dairy operations, I often will disregard the “Other Income/Loss” section of the income statement unless the activities presented in the section are vital to the operations.
For example, I would not include gains or losses on the sale of equipment as this would most likely be a one-time activity and, therefore, not a part of the core operations. As stated above, our goal is to identify the cash generation potential of the main business operations.
B ‘Before’
We are going to add back the following four expenses: interest, income taxes, depreciation and amortization.
I ‘Interest’ – Add back the interest expense paid during the period
Make sure to find all the interest paid during the period. Some dairy financial statements have a number of different schedules, so interest expenses may be broken up into different schedules. The best place to find your interest expense total is often on the statement of cash flows.
T ‘Taxes’ – Add back the income taxes paid during the period
While every operation is different, many dairies are structured as flow-through entities for tax purposes. For this reason, we will often not see income taxes paid out of dairies. If your dairy is set up this way, you will likely not see any income taxes on the financial statement or in your EBITDA calculation.
D ‘Depreciation’ – Add back both herd and other depreciation expenses incurred in the period
This is where EBITDA has often been misused on dairies. There has been a lot of discussion in the dairy industry on what to do with herd depreciation when calculating EBITDA.
If we back out herd depreciation, we will also need to adjust for heifer capitalization for dairies that raise their own replacements. We will discuss more in depth further below. Like interest expense above, the statement of cash flows is often the best place to find depreciation expense totals.
A ‘Amortization’ – Add back all amortization expense incurred in the period
You can find amortization expense on the statement of cash flows.
You have now calculated EBITDA for your dairy. In many industries, such as manufacturing, you might be able to stop here. However, as I mentioned before, there are a few other nuances of dairy operations that need to be addressed – most importantly herd growth and heifer capitalization – before we are finished.
Heifer raising requires a tremendous amount of cash. While this cash expenditure is capitalized on the financial statement, it does impact a dairy’s ability to service debt, cash flow and withstand down cycles in the market. This number is important to include in our calculation to arrive at adjusted EBITDA, which will give us the whole story.
To calculate adjusted EBITDA, start with your EBITDA number calculated above. Then subtract the capitalized cost of heifers. This amount can be found on your income statement or on the statement of cash flows and represents the costs the dairy incurred raising heifers in the period.
Next, add your loss on sale of cows and heifers. (If there is a gain on sale of cows and heifers, you will subtract instead). Next, add back cow and heifer proceeds. This is cash you have received from the sale of animals and is available to service debt. Last, subtract the amounts you paid to purchase cows and heifers. You have now arrived at adjusted EBITDA.
EBITDA
(-) Heifer capitalization
(+) Loss on sale of cows and heifers
(+) Proceeds from sale of cows and heifers
(-) Purchase of cows and heifers
= adjusted EBITDA
So what does adjusted EBITDA tell us? Adjusted EBITDA represents the amount of cash an operation generates prior to servicing debt and personal draws.
With adjusted EBITDA calculated, you can feel confident knowing the amount of debt your operations can service on potential expansion projects, understand your operation’s exposure to fluctuating milk and feed prices, and evaluate the impact of heifer-raising activities on your operations’ profitability.
The dairy industry is ever-changing; using adjusted EBITDA will bring some stability to your decision-making process and help evaluate the next best steps toward maximizing efficiencies. 
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Leland Kootstra
- Agribusiness Consultant
- Frazer LLP
- Email Leland Kootstra
