This year has certainly been challenging for dairy producers. Milk prices “tanked” in January and have generally not recovered. This has made it nearly impossible for most dairy farmers to cash-flow their operations.
The challenge is to decide whether it is worth borrowing operating money in the short-term to cover the difference between monthly milk sales and monthly cash production cost — including feed expenses, hired labor and family living.
This borrowing only makes sense if conditions will change so that you can cover your normal cash cost and retire operating loans you take out to stay in business. The point is that financing a short-term cash-flow deficit puts you in a position where you will have to generate even higher cash-flow surpluses in the future.
For example, assume that a dairy producer’s cash operating cost is around $16 per hundredweight and the milk price is about $12 per cwt.
The producer in question believes that milk prices will rise over the next few months such that in six months, the price of milk will be $16. This price recovery will improve the producer’s cash-flow situation. But it will not necessarily put him back into a positive cash-flow position.
His cost of producing milk is not going to hold constant at $16 over the six months that it is assumed milk prices will be rising. Instead, the cash cost of production is going to rise as he borrows operating money to cover monthly cash-flow shortfalls.
Money isn’t free
These potential cash production cost increases of this hypothetical producer are laid out in the table below. The cost of financing cash-flow deficits with operating loans are reflected by the values in the far-right-hand column.
The key thing to note is that even though the milk price is projected to rise to $16 by month six, he will still experience cash-flow deficits. This is because the cash cost rises as money is borrowed to finance monthly cash-flow deficits. The increased cash cost is the payment the producer is expected to make on operating loans.
Therefore, it is critical that you account for the fact that borrowing to cover cash-flow deficits in the short-run increases your cost of production in subsequent periods.
Weigh the payback
It is understandable that you would be willing to take out short-term operating loans rather than shut down. But you have to understand that you are setting yourself up for more potential cash-flow problems by borrowing more and more operating money.
As these short-term debts mount, the cash cost of production also rises. This higher production cost can only be covered if milk prices rise to levels that will cover base production cost and payments (principal and interest) on operating loans.
If this is not likely to occur, it may advantageous to cease operations versus rack up even more debts that cannot be serviced. This may not be the desired option, but it may be preferable to allowing one’s equity to erode to a point that there is a foreclosure or bankruptcy.
Bruce Jones is a professor of farm management at the University of Wisconsin-Madison.
The monthly operating loans are computed by multiplying the net cash deficits (negative net cash flows) by 0.087, which is the amortization factor for 12 monthly payments at 8 percent interest.
Source: University of Wisconsin