With milk prices higher than they have been since 2008, many producers are finding they have more money left over each month after paying operating expenses and normal principal and interest payments. Many have paid off or drastically reduced operating debts incurred in 2009. Taking advantage of their increased cash positions to evaluate various options which include paying down debt, these operators are generally prioritizing debt reduction as follows: 1. Accounts payable 2. Operating lines/feed lines 3. Intermediate-term cow lines/equipment loans 4. Long-term facility/real estate loans

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Larry Davis

While there certainly may be circumstances in which an operator would prioritize debt reduction differently, accounts payable should generally come first because they normally carry the highest interest rate. This category would of course include feed, supplies, equipment parts, crop inputs and other common expenses.

Typically, debt of this nature will carry interest rates of 18 percent or higher because suppliers are not in the business of making operating loans, and they want to be paid on a monthly basis. These suppliers are very important to an operation because they provide the lifeblood a dairy operation needs each month.

Unfortunately, these businesses many times end up financing cash-strapped dairies. If extra cash is available, operators should pay off these folks.

Bank operating lines and bank feed lines would normally be the next debt category to be paid down or paid off if extra cash is available. Typically, these are revolving credit facilities set up with the bank, and they carry a variable interest rate. These loans are designed to provide cash to pay operating expenses and should revolve up and down depending on cash available.

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They should be used for operating expenses and not for the purchase of intermediate or long-term assets such as cows, equipment or land. Although variable interest rates on such loans have stayed low in recent years, they do have the potential to rise along with rates generally. Someday this will happen, so be prepared and pay off these loans when cash is available.

The next broad group of debt facilities an operation might consider reducing or eliminating with extra cash is intermediate-term cow loans and/or equipment loans. Normally, these loans are on a term structure, meaning they have some sort of fixed principal repayment schedule.

They may have fixed or variable interest rates, depending on how they were structured. Typically, if an operation has several different loans of this nature, it might choose to pay off or pay down those with the highest interest rates first.

One consideration operators need to make is if they can borrow back funds once these facilities are paid off or paid down. Being able to maintain liquidity is very important to a dairy operation, as many realized in 2009. As we saw in late 2008, the economic environment can change very quickly, as well as a bank’s appetite to lend.

If shorter-term debt has been paid off and interest rates on intermediate debt are low, then it might behoove an operation to put aside extra cash in the bank and leave these credit facilities alone. On the other hand, if interest rates are high on this debt, relative to what an operation may be able to obtain currently, reducing or eliminating this debt might be the best use of cash.

The final category of debt that can be reduced or eliminated is long-term facility or land debt. In most cases, this should be the last debt considered for reduction. Typically, this is financed on 15-year to 30-year terms with fixed interest and principal payments. So normally an operation would want to consider refinancing this debt at lower rates, as opposed to paying off early.

Extraordinary events, such as inheritance or selling part of the farm or business, might provide the right opportunity for reducing debt in this area. In recent years, with fixed interest rates being at historic lows, most debt of this nature has been refinanced and is at a very competitive rate. It is highly unlikely long-term fixed rates will stay at the levels they have been in recent years.

A dairy operation should take advantage of these low rates and maintain liquidity by keeping extra cash on hand for hard times if payments of this type of debt are at comfortable levels. However, if the operation has paid off shorter-term debt and has an excess of long-term debt at higher interest rates, it may be good to pay down this debt and reduce leverage so that obligations are easier to meet when cash flow is not as plentiful.

Certainly, if shorter-term debt is available, then it may make good sense to pay off longer-term debt when times are good.

Of course, debt reduction may not be the right use for cash in a growing operation. If strategic plans are to increase the size of the operation, then investing in cows, facilities or land may be a better use of extra cash. Using extra cash for an expansion would take an operation down a much different path and would include consideration to current and future debt structure.

Reducing debt with extra cash in these better times can make a lot of sense for an operation. Operations should invest time in careful planning and thought before implementing debt-reduction strategies. PD

Larry Davis