I am on the fence, it is a barbed-wire fence, and I want to get off!
As I write this article, there is a breath of optimism in the dairy industry. Markets have improved, government program payments are getting to mailboxes and the economy is slowly opening back up. That is good news that I hope only gets better. For some dairy businesses that is just the spark needed to enthusiastically look to a better future. For others, the current news is welcome, but the need to consider the future of their operation is still at hand.
Previous articles in this series of managing through COVID-19 have focused on two potential groups that dairy businesses may find themselves in, Long-Haulers and Guardian-Transitioners. Long-Haulers are those who have made the decision to stay and succeed in the dairy industry and have the short-term need to cash flow until better profitability (see “Cash Flowing to the Other Side of COVID”). Guardian-Transitioners are those that have made the decision to succeed in the future by guarding their equity through transitioning to some new business model or exiting the business (see “Standing Strong and Resolute as a Guardian of Your Equity”). The third group is “On-the-Fencers”.
On-the-Fencers are undecided about what to do next. Indecision may be due to not seeing a path forward, seeing multiple paths but struggling to choose one, or being paralyzed by how to even start the decision-making process. Financial and other stressors from the pandemic may have brought a sharp edge to this indecision, but other factors such as health, age, infrastructure or family dynamics may play significant roles. Whatever the cause, the result is an internal ticking clock constantly reminding you that decisions must be made, itself a stressor, triggering a paralysis in how to make those decisions. I am on the fence, it is a barbed-wire fence, and I want to get off!
Figure 1 shows a roadmap for potential ways off the fence. It starts with determining the capacity for long-term profitability under “normal” production, prices and costs of production.
If the answer is “Yes”, then you may be in the “Long-Hauler” camp with its accompanying options (Figure 1). In the short-term, that may mean a focus on cash flowing to the other side of the pandemic. In the long-term it means an option to stay the course with continuing operational improvements to take advantage of future opportunities and efficiencies.
If the answer is “No”, then you may be a Guardian-Transitioner. Your very short-term may still be a focus on cash flow, but the bigger decisions are how to effectively make significant and strategic changes that guard your equity through transition to a different business strategy or exit from the industry. Either way, the goal is to make it your proactive choice.
Let’s back up! Answering the question, “Does this operation have the capacity for long-term profitability?” is a difficult question to answer. Ultimately, it involves in-depth trend analysis of financial position and performance, peer group comparisons, burn rate analysis and pro forma budgeting under different scenarios of prices, production and costs of production. When ready, assistance from consultants, Extension educators, vocational instructors and others who have the experience and expertise to guide you through your specific situation will be very helpful. Until then, there is a need to get started and gain a first blush of awareness.
Table 1 shows historical annual average, low-third and top-third Class III prices. Using these prices along with your usual basis (add your basis to the Class III price), ask yourself which answer below, A or B, bests describes your opinion to the question, “During times of average milk prices, I can …:”
- pay my bills, cover debt service, replace/update some machinery, buildings and technology and even save a little cash to cover unusual expenses that come up or stash it away in equity.
- pay my bills, but I still struggle to meet all my debt service and my machinery, buildings and technology continue to grow old, obsolete and inefficient (I just can’t afford to replace or update). I have very little cushion and worry that I’m one major breakdown or price drop away from real financial problems.
Table 1: Class III Annual Prices
|Approximate Low Third Price1
|Approximate Top Third Price
1 Low and Top third prices based on Average minus or plus one-half standard deviation.
Now, ask yourself the same question if prices are in the low-third. If you agreed with answer “A” under most, even low third, price scenarios, that is an early indication that you might be a “Yes” to the question of long-term profitability in Figure 1. If you agreed more with answer “B”, even under top-third prices, then it might be an indication of a “No” answer in Figure 1 and long-term profitability may be a challenge unless something changes.
This is obviously not a rigorous analysis, only a baby step forward. A step up in rigor is analyzing the trends of profitability metrics such as the long-term average Return on Assets (ROA). Return on Assets is a measure of how much profit the business is earning from every dollar of assets. It is a common financial metric calculated in financial record-keeping systems and one that is comparable to peer group and industry standards. Table 2 shows ROA industry standards and recent statistics of actual dairy farms.
The first row in Table 2 shows the suggested benchmark based on the Farm Financial Standards Council. Over time, the goal is to be at least greater than 4% and ideally greater than 8%. Note, this will adjust somewhat depending on the level of ownership of your capital assets (higher by a couple percent if you lease most of your assets, lower by a couple percent if you own most of your assets).
However, profitability in the dairy industry has been anything but normal the last few years. Thus, for those years, the rest of Table 2 provides comparative statistics of actual farms from FINBIN and FarmBench databases. The statistics are for both a four-year period that does not include the high profit year of 2014 and for a five-year period that does include 2014. In the first set of statistics, farms were separated by ROA into groups based on the lowest 40%, middle 20% and highest 40%. The statistics show the average ROA within each of those groups. If your ROA is in the top 40% then it is an indication that the business is “keeping up” with industry leaders with respect to profitability. ROA in the low 40% could be an indicator of profitability challenges. A second set of statistics separates groups into the lowest 30%, middle 40% and highest 30% with the number in the table being the breakpoint price between those groups.
If after considering the A vs B question and analyzing ROA, you answer “Yes” to long-term profitability (Figure 1), then you may be in the Long-Hauler camp. Your current focus is cash flow and in the long-term continuous building of efficiency in your operation.
If your analysis leans more to a “No” answer to long-term profitability, you may be in the Guardian-Transitioners camp. In the short-term, cash flow is still a focus, but future plans may focus more on how to guard your equity through a more significant and strategic transition to some other kind of business model, partial liquidation or exit from the industry. There are a host of reasons that might have created this situation, most if not all may have been outside of your control. Regardless of your situation today, what is important is taking the proactive step to change your future trajectory to a better path for you, your business and your family.
Remember, the A vs B question and analysis of ROA is an initial awareness of the operation’s capacity for sustained long-term profitability. You will certainly want to follow this with a more rigorous analysis of financial statements, pro forma budgeting and an internal check on non-financial reasons for being a Long-Hauler or Guardian-Transitioner.
Whichever way off the fence you feel is most prudent to pursue, what is important is that you are taking charge of your destiny. It is your data-driven choice and you are making the proactive decision to move and create a better path for your operation and your family.