No doubt about it, financial factors affecting your dairy have been rather grim lately. The past 22 months of low milk prices, rising feed cost and challenging weather have created difficult debt-management conditions. And although borrowed capital is a fact of life on dairies, these factors have increased debt loads beyond desirable levels for many producers — which has significantly reduced operational cash flows and taken a bite out of owner equity.
On the other hand, improving milk prices and exceptionally low interest rates signal an opportune time to restructure your debt. And doing so can improve your dairy’s profitability, financial outlook, and ability to take advantage of opportunities that arise.
“You need to position yourself for long-term viability as well as position yourself for the next crisis,” says Terry Johnson, vice president and branch manager with FCS Financial Services in Thorp, Wis. Restructuring your debt will help you do that.
Now is the time to examine your debt picture and do something about it.
Restore your financial strength
Most producers are currently putting together their 2004 business plan. And, in order to avoid a replay of last spring’s tight-credit scenario, you need to make some changes now.
Restructuring your debt — short-term, intermediate and long-term — can help you improve cash flow. For example, some producers who got pinched by low milk prices have found themselves with a current ratio — current assets to current debts — of 1:1 or less. And financial experts note that it’s very difficult for a business to remain in business for long when ratios get to these levels. Restructuring you debt can help you improve that ratio and give your business better financial footing.
“It takes a very strong business to be able to withstand that much financial pressure, and most dairies are not in a position to hold out until their current ratio turns around,” says Dan Wenzel, of Wenzel Dairy Business Consulting, LLC, New London, Wis. That makes restructuring debt a top priority.
Right now, you have equal opportunity to affect short-term and long-term debt. However, the only way to be certain that restructuring debt will have a positive impact on your business is to have an accurate and complete accounting of your business’ financial position.
“Two areas people often fail to account for on their balance sheets are credit-card debt and leases,” says Gary Sipiorski, president of Citizen’s State Bank of Loyal, Loyal, Wis. Both can drastically impact cash flow. Credit-card debt usually carries high interest rates. Leases, although not a liability, are a draw on your cash flow and must be noted on your balance sheet.
The honesty doesn’t stop there. You must also get an accurate picture of family living draw, depreciation schedules, actual cash flow and feed inventories on an accrual basis. “These may be ugly numbers,” says Sipiorski, “but you must look at them if you want to ultimately improve your situation.” Failure to do so leaves you exposed to intermittent and unexpected cash-flow crunches.
Increase cash flow
Restructuring debt is not a cure-all. You must be realistic in your debt-reduction goals, says Stephen Harsh, Michigan State University ag economist. “If your goal is to improve cash flow, then the cost for both principal and interest paid on loans must be less than what you paid previously.”
That’s where restructuring comes into play. You can:
• Combine short-term liabilities into a single short-term loan with more favorable interest rates.
• Roll several intermediate debts into one loan at a lower interest rate.
• Lengthen the term or negotiate a lower interest rate for long-term loans.
While this strategy calls for you to move some debt down the balance sheet — usually a major no-no — this is a situation where it makes sense to do so.
“Even if you refinanced and locked-in a rate on a five- to seven-year loan three years ago, it may be worth your while to investigate further rate reductions,” suggests Wenzel. “In some cases, even with early payoff fees, the interest you save by refinancing will be greater than penalty fees incurred.” And the action lowers your payment, which, in turn, frees up cash flow.
For example, let’s say you have a five-year equipment loan with a $51, 288 balance at an interest rate of 9.3 percent. And you have just more than three years left to pay on it. If you restructure that debt into another five-year loan (still within the equipment’s useful life) with an interest rate of 5.4 percent, no penalty fees and a 1 percent processing fee, you’ll save $21,465 in interest and principal payments.
Just remember, you must make good use of this available cash flow or you’ll find yourself deeper in debt. “This is an opportunity to take care of lines of credit, invest in producing assets, like cows, and reduce short-term payable balances—not buy a new pickup at zero percent financing,” cautions Sipiorski.
Interest rates will change
Probably the most compelling reason to restructure your debt now rather than later is interest rates. Although they have inched up and down during the past six months, rates are still lower than they have been in years. “There’s never been a better time to restructure debt,” says Harsh.
“Rates have moved around a bit since the spring, but when you put them in context, we’re still at historic lows,” agrees Johnson. “And that offers producers some good opportunities to deal with their debt.”
If you compare a $500,000, 15-year loan with an interest rate of 7.33 percent —like it was 10 years ago — and the exact same loan taken out today with a 5 percent interest rate, there is a $7,595 annual savings with the lower rate. The charts on page 24 show where interest rates have been historically and how much you can save when you reduce interest rates.
However, no one knows how long these low rates will stick around — especially as the overall economy starts to gather steam.
Stop waiting for the absolute lowest rate you can get; you probably have already missed it. Instead, use this opportunity to drop the interest rate you pay on intermediate and long-term loans. Doing so will reduce your interest payments and increase your cash flow — perhaps significantly — depending on how high your original rate was locked in.
And you can take that savings to the bank.
To address your debt, here are four areas that need your immediate attention:
• You must reduce balances on short-term liabilities, or payables due within 12 months, as soon as possible to lessen the impact of high interest rates usually associated with these accounts. This, in turn, quickly and positively impacts your cash flow.
• You must begin making principal payments if you have been on interest-only status on your loans to help reduce your overall debt. Delaying these payments may be appropriate in the short run during really tight cash flow situations, but you must address this when cash flow improves.
• You must pay down your line of credit so this “shock absorber” is available to you during the next down-phase of the dairy business cycle.
• You must take care of deferred maintenance issues so that equipment and facilities remain in good operating order for as long as possible. Again, while appropriate to delay during difficult times, you must revisit this area as soon as your situation improves.
“You need to deal with all of these areas before you ever buy anything new when cash flow improves,” says Gary
Sipiorski, president of Citizen’s State Bank of Loyal, Loyal, Wis.
Do your homework about how restructuring debt will work on your operation before you meet with your lender. Don’t expect to waltz into your lender’s office and hope he can help you. Be prepared with realistic expectations and accurate financial details, so you can work together to craft a viable solution for your situation.
Here’s what your lender will want to see when you meet to go over your restructuring plan:
Current balance sheet.
Last year’s cash-flow statement.
2004 projected cash-flow statement.
2004 operating plan that shows how the funds will be used on your dairy.
Current cost-of-production figures.