If you own a dairy farm, at least some of your equipment, facilities and other key business components must be replaced on a regular basis. Or you decide to change, upgrade or expand your business to maintain your competitive edge.
Either way, you’re staring down a capital asset purchase and you must gather the appropriate data so you can evaluate investment alternatives as thoroughly as possible. Failure to do so, or the use of inaccurate or incomplete data, results in misleading conclusions. And that leads to bad outcomes for your bottom-line.
Think about what you need, what the return is and what you’re risking, and think about that carefully, says Brent Gloy, Purdue University agricultural economist. “On the other hand, you don’t want to walk away from things that fit with what you do and that you’re capable of handling.”
Use the following factors to analyze capital purchase decisions.
Given the state of the national and dairy economies, the impact of any large purchase on working capital is your first concern when it comes to capital purchases these days.
If you’re considering something like a remodel, or building new facilities, make sure you keep your eye on the budget, advises Barbara Dartt, senior family business and management consulting with Lookout Ridge Consulting. Dartt is based in Portage, Mich. “A lot of times during the course of these projects, cost over-runs or unanticipated expenses are covered out of your cash reserves, so spend extra time and attention on your budgets to prevent these draws. You really need to run your numbers and make sure you keep working capital at the forefront of your decisions.”
Year-in, year-out, Dartt and her colleagues recommend that you spend an average of 5 to 6 percent of gross sales annually on maintenance capital — the money needed to maintain or replace existing assets. Keep in mind that capital growth needs are in addition to maintenance, and must also be analyzed given current conditions and your business plan. In both cases, the analysis should consider cash-flow first. Working capital is king.
Impact on farm strength
Your operation’s overall economic strength is another factor to consider when analyzing your ability to add or replace capital assets.
Use these four measures of your farm’s financial strength in your overall evaluation:
Liquidity. Also known as cash flow, this is your business’ ability to meet short-term financial obligations. It is not the same as profitability. Measure your liquidity by subtracting current liabilities from current assets, then dividing by annual revenue. Shoot for more than 15 percent.
Solvency. This is a measurement of how much of your business’ assets are classified as equity vs. debt. It is synonymous with net worth or owner equity. To find this figure, divide total equity by total assets using a market-value balance sheet. The goal is to be higher than 50 percent.
Capital efficiency. This is a way to measure how well your capital assets generate revenue. It can be measured by comparing revenue to fixed assets. This value will vary by your mix of land, depreciating assets and leased assets. It also depends on the useful life of your depreciating assets. Work with your financial advisor to determine this figure and what it means for your business.
Debt repayment capacity. This lets you know if your business generates enough cash to cover debt payments. It can be measured by dividing annual dollars available by scheduled debt and lease payments. You’re in good shape if this measure is 1.20 or greater.
“Too many times, we get wrapped up in thinking of the big picture and we don’t think about the fundamentals of our business,” Gloy says. “Start by understanding where you are and what your options are to change where you are.”
Lease or buy?
Visit with your financial advisor about the potential tax implications of leasing, as well as purchasing your new asset.
You must also consider financing terms and what these mean to your business. For example, shorter financing terms mean the new purchase is paid for more quickly. But, you will have to allocate more working capital toward repayment.
Longer terms require less demand on working capital, but result in more interest paid.
“We’re looking at shorter-term, more immediate payback opportunities with our clients,” says Dartt.
In addition, if you have an operating loan, you must also take it into consideration. Remember, paying off term debt may result in trading term interest rates for operating loan interest rates.
Debt is a valuable tool for business growth, but evaluate its use carefully. Don’t threaten your financial security via unnecessary debt expenses. Opportunities may come up, and you may need to borrow money to go after them, says Gloy. However, he suggests that you borrow in moderation and that you use the funds for the right things, the things that move your business forward.
Down-time vs. up-time
The next factor to consider is how much revenue will you lose, or additional cost will you incur if your current equipment breaks down at an inopportune time?
This is a financial risk that can become severe if critical work on your dairy cannot be completed in a timely fashion. Lost production, lost productivity, as well as repair expenses (especially repeat repair bills) can add up quickly.
Likewise, factor in size and performance standards as you evaluate capital purchases. Do you need a larger tractor that matches better with the horsepower requirements for your mixer? Or should you simply replace your aging unit with one the same size because it gets the job done as is?
Depending on your long-term plans and the asset under consideration, the best decision may be to table your decision until a later date.
Talk it over
While the accurate facts and figures are imperative to your decisions, don’t forget about communication. Talk to your business partners, family members and financial partners throughout this process to ensure success.
Develop and follow a capital plan. And keep everyone in the loop regarding its implementation.
Set your farm’s working capital minimums and equity minimums with key individuals, suggests Dartt. “Then you have a mechanism in place to discuss and decide what happens if you are not in compliance with these figures, or when it’s OK to modify your compliance.”
What’s a capital asset?
Capital assets are those items that are expected to last beyond one production cycle and, more importantly, their employment is the foundation of future farm income, according to economists at the University of Wisconsin. Capital assets include things like cows, facilities, tractors or land.
Two fundamental tasks required
Selecting investments that will improve the financial performance of your business involves two fundamental tasks, explains Mike Boehlje, Purdue University agricultural economist. These are:
An economic profitability analysis.
A financial feasibility analysis.
As the name suggests, an economic profitability analysis will show if an alternative is economically profitable. However, an investment may not be financially feasible, meaning the cash flow may be insufficient to make the required principal and interest payments.
So, you really need to do both analyses before making a final decision about a particular purchase or project.
Completing a thorough investment analysis may seem complicated and difficult, Boehlje says. “But the reward of a soundly based decision will be worth the effort invested to learn the process and collect the necessary information.”
Keep your covenants
If you do decide to borrow funds for a capital asset purchase, keep in mind that lenders are going to watch loan covenants carefully. These are the agreements contained within loan documents that set up performance parameters. For example, a covenant may only allow you to spent $250,000 in capital asset purchases in a year.
Failure to abide by these covenants may result in penalties, increased interest rates or even the early call of a loan.
“This is driven by financial regulators, says Barbara Dartt, senior family business and management consulting with Lookout Ridge Consulting. “They are watching banks very closely on these, so therefore, your banks are watching you more closely. Keep in regular contact with your banker. You’re going to be asked to track and prove that you do what you say you are going to do.”