Dairy industry economics are hotter than a pepper sprout, analogous to the lyrics of Johnny and June Carter Cash’s old country song. High milk prices coupled with lower feed costs and an extended duration of low interest rates finds this industry in the top of the cycle. During a recent webcast, I recommended that dairy producers maintain a 33% working capital to farm revenue ratio.
A well respected webcast attendee asked me an interesting follow-up question. While 33% working capital to revenue is appropriate for cash grain and market livestock businesses because of significant inventory, is this level of working capital too aggressive for dairies, since milk inventory is picked up every day or every other day? This excellent point made me ponder as I was baling hay in the scenic valley in the Blue Ridge Mountains Memorial Day weekend.
The attendee had further examined FINBIN farm financial data sets and found that the average working capital to revenue was 15.2% for dairies with 500 cows and above, and 17.4% for all farms with greater than 100 dairy cows from 2009 to 2013. This was a good starting point that provoked thought while the computer baling system routinely wrapped and kicked out bales for our dairy and beef herds.
I agree that dairies often carry much less inventory than grain and market livestock operations, which needs to be taken into account. However, looking at FINBIN data, if one examines the top 30% compared to the bottom 30% of dairies, my recommendation comes more in line. Examining the period from 2011 to 2013 as the profit cycle was on an upward swing, the top 30% of producers had 24-54%, or an average of 39%, working capital to revenue. On the other end of the spectrum, the low 30% of dairy producers showed a range of approximately -16% to 5%, with an average of -6% working capital to revenue. Particularly when the dairy industry is in the top of its cycle, similar to where the grain industry was a few years ago, the stretch metric of 33% is a goal to which producers can aspire for working capital to revenue. However, I would like to caution that one ratio does not make a successful business. The degree of financial leverage, consistency of profits, operating margins and the debt coverage ratio, among others, also need to be assessed.
The original Farm Financial Standards Task Force, which I facilitated, had much discussion concerning financial liquidity on dairy farms versus other agricultural segments. Back then, little variation in milk prices and feed costs nearly kept this criterion out of the recommendations. Today, with wide double-digit swings in milk prices, feed costs to dairies exhibiting similar variations, and possibility of interest rate increases, the working capital shock absorber needs to be set high, particularly in this part of the cycle which is at its peak, as the top one third of managers have exhibited in the analysis. Instead of inventory sold as corn, hay or bean sales, it is produced through the cow on dairies. Thus, sufficient inventory is needed along with some good old-fashioned cash.
As a true complement to the person who asked me the question, there is no right or wrong answer. The level of liquidity must be aligned with producers’ and in some cases lenders’ goals and their appetite for risk, which often raises its ugly head in the waning end of the cycle, now being observed by crop producers.