The following financial question from a producer at a recent conference caught our attention: “In 2014, what percentage of a producer’s gross income should be in current assets? How has this percentage changed in the last five years, and how might it need to change in the next five years?”

While this ratio isn’t a typical way of measuring a dairy’s financial strength, it did get us thinking about the various ways dairy producers can measure their financial strength as well as ways they can position their operations for future success.

A single measurement doesn’t necessarily indicate the true financial health of an operation; rather, a combination of key performance indicators (KPIs) can be used to determine the strength of a dairy producer’s financial position. Let’s explore where the industry has been, where it is going and which KPIs can help producers measure financial strength.

Where we have been
Prior to 2009, banks would typically lend a higher percentage of debt to a dairy producer for the dairy herd and feed inventory. Also, the value the bank assigned to the dairy herd was higher than it is today, which meant the dairy producer could have more debt than what is currently allowed and still be in compliance with loan covenants.

This is measured on what is called a borrowing base report (BBR). A typical percentage of debt on the dairy herd and feed – or loan-to-value (LTV) – prior to and during 2009 was around 75 percent. Today, the required LTV is closer to 65 percent or lower.

During 2009, the average loss for a dairy producer in our home state of Idaho was approximately $4.15 per hundredweight (cwt). Assuming a 65-pound herd average, this equated to just under a $1 million loss for a 1,000-cow dairy operation.

To put this in terms of the question posed in the introduction of this article, a dairy producer would have needed to have 35 percent of its gross income for 2009 in available current assets (“available” means after current liabilities are paid) in order to cover the losses in 2009 without borrowing any more money.

Working capital, or current assets less current liabilities, is a better measurement to analyze as a percentage of gross income versus current assets by itself. The amount of current assets doesn’t give us the whole picture and doesn’t tell us what is available to finance operating losses.

Let’s look at this in terms of the BBR and what the LTV would have needed to be prior to 2009 in order to have the availability on the operating loans to fund the $4.15 per cwt loss and remain in compliance with loan covenants.

Assuming a bank value of $1,400 per cow and a total of 1,200 cows (1,000 milking), at 75 percent LTV a dairy producer would have a borrowing limit of $1.26 million against the cows.

To cover the $1 million loss, the dairy producer would have needed to have $260,000 borrowed on the cows before 2009, which equates to an LTV of about 15 percent or $217 per cow. This analysis only looks at the cows and doesn’t consider the lendable equity in the heifers, feed, equipment, real estate or other assets of a dairy operation.

Where we are going
That’s enough with 2009 and the issues created by the 12 to 18 months we all want to put behind us. However, there were many important lessons learned from that time. Let’s discuss where we are today and where the industry is going as it relates to bank financing and a dairy producer’s financial strength.

Today, most dairy lenders are targeting a maximum LTV on the BBR of 65 percent, and the bank value assigned to the cows ranges from $1,200 to $1,400 per cow.

The other major change from pre-2009 is: A dairy producer is no longer able to borrow 100 percent of the value of feed inventory and is required to be in the 65 percent to 90 percent range.

Some lenders will loan higher percentages on the feed inventory, but that is typically coupled with an amortized herd loan that doesn’t revolve like a typical operating loan for the herd. The lower borrowing limits have forced dairy producers to change the way they manage the finances for their operations in order to mitigate the up-and-down swings of the market.

One of the main buzzwords or phrases that came after 2009 is “hedging” or “risk management,” and many dairy producers have taken this to heart. The amount of lendable equity or liquidity a dairy producer needs to ensure long-term sustainability depends on the producer’s risk management strategy.

A dairy producer that consistently hedges both milk price and feed cost reduces the risk the dairy will incur significant losses. However, a dairy producer who doesn’t hedge consistently is at more risk of market volatility and needs more lendable equity or liquidity to withstand the volatility.

So far in 2014, we are seeing unprecedented profits, and dairy producers are taking advantage of the current market to decrease their leverage and increase their equity and liquidity.

Key performance indicators
Let’s discuss some of the KPIs a dairy producer should be monitoring and what levels they should be targeting and setting goals to achieve. Following is a list of KPIs and a short description of each.

Please note that these KPIs are for financial performance and not operational performance. For example, KPIs for operations would be pounds per cow, milk components, turnover rate, etc.

• Borrowing base LTV and margin – We’ve discussed this in the previous sections of this article, but a dairy producer should be monitoring, on a monthly basis, his or her LTV and available borrowing base margin to ensure compliance with loan covenants and LTV improvement.
  
• Current ratio – The current ratio is calculated by dividing current assets by current liabilities. Current assets typically consist of cash, receivables, inventory and prepaid expenses. Current liabilities typically consist of accounts payable, feed operating loans, accrued liabilities and the current portion of long-term debt payments.

  A ratio of 1-to-1 means a producer has $1 of current assets for every $1 of current liabilities owed. The higher this ratio is, the more liquidity the dairy operation has. Another way to measure this ratio is to include both the herd value and herd operating loan in the calculation. We suggest calculating it both ways and setting targets for each.
  

• Total debt to total assets – This is a measurement of a dairy’s leverage and how much of the assets of an operation are financed with debt versus equity. This should be measured using both the cost basis of the assets (what’s reported on your financial statement) and the market value of the assets.

  Similar to a BBR, which measures this on the cows and feed, the total debt to total assets using the market value should be at 65 percent or lower. The lower this ratio is, the more equity the dairy operation has.
  

• Debt service coverage ratio (DSCR) – This is a measurement of the amount of cash flow generated by a dairy operation that is available to service the required debt payments, both principal and interest. Like the current ratio, the higher the ratio the better.

  For example, some banks require anywhere from a 1.1-to-1 to a 1.25-to-1 ratio. This means that a dairy operation has to generate $1.10 of available cash flow for every $1 of principal and interest payments that are required to be paid.

The above are some of the financial KPIs a dairy producer should measure on a monthly basis to track progress and to ensure the operation is in line with forecasts and set up for future success. These measurements will give the dairy producer the information to take corrective action, if needed.

Dairy producers should use a benchmark to measure their financial strength. That benchmark can be industry averages, but more importantly it should be meaningful to the dairy producer.

While the industry is currently enjoying profits, it is important to remember where we have been and what can be done to ensure future success. Using an effective risk management strategy, along with KPIs to measure financial success, will help in the pursuit of financial strength and stability. PD

Scott Plew works for Cooper Norman, an accounting firm based in Twin Falls, Idaho, that specializes in the dairy industry.

Scott E. Plew
CPA
Cooper Norman