Saturday, April 19, 2014

Managing Drought Risk on the Ranch

Indicators of the Ranch's Financial Health

*Excerpted from Assessing the Economic Status of Your Beef Cow Herd, by Harlan Hughes, Tim Cross & Lee Meyer

Measuring Liquidity - Cash flow

Cash flow is a measure of a farm’s or ranch’s ability to meet cash expenses and cash payments as they occur and provide for unexpected events. Cash expenses and payments include items which will be paid within a given time period (usually the next 12 months).

Annual net cash flow is calculated as projected annual cash inflows minus annual cash outflows. This measure encompasses all expected sources and uses of cash over the next twelve months, and can be used to anticipate liquidity problems before they occur. A monthly projected cash flow can also be constructed to calculate net cash flow by the month, and this statement can also be used to determine operating capital borrowing needs and repayment abilities from month to month.

Measuring Solvency - Debt/Asset Ratio

This is calculated as the total outstanding debt on the farm or ranch divided by the total value of all farm assets. It estimates the percentage of the farm which is debt-financed.
 

For example, an operation with a debt of $150,000 and assets valued at $225,000 would have a debt to asset ratio of 67% ($150,000 / $225,000), and would be at considerable financial risk. An operation with the same debt but with $450,000 of assets would have a debt to asset ratio of 33%. Both operations are solvent because debt is less than asset value.

A lower debt to equity ratio indicates greater solvency and a greater ability to withstand short-term operating losses. Debt to asset ratios of about 60 percent suggest that serious attention is required during periods of low prices and incomes. Ratios from 40 to 60 percent are acceptable, but in beef operation, more so than for other types of farms, debt loads should be closely monitored to insure that progress is being made toward reducing the ratio over time. Ratios less than 40 percent show reasonably good potential for long-run financial health.

Measuring Solvency - Net Worth

Net worth is another good measure of solvency. Calculated as total assets minus total liabilities, it shows the owner’s equity capital in the farm or ranch. Net worth is increased by 1) generating profits, 2) appreciating asset values over time and, 3) debts being retired. Farms with small net worth values are less able to withstand financial losses compared to similar farms with large net worth values.

Measuring Enterprise Performance - Unit Cost of Production

Cattle production costs are not directly tied to cattle prices, so cost may be unchanged even though revenues decreased substantially. Low unit cost herds can survive down markets and drought stress. High unit cost herds are at risk of having to sell out. Your ability to cope with a down market will depend on your herd’s unit cost of producing a hundred weight of calf. You absolutely have to know if you are a high cost or low cost producer. Measure with Unit Cost of Production, and compare to benchmark herds.

Putting It All Together

Problem Indicator Summary

Problem Area

Measures

Not A Problem

Caution

Serious Problem

Liquidity

Net Cash Flow

Large Positive

Small Large Negative

Solvency

Debt to Asset Ratio

Net Worth

Change in Net Worth

< 40%

Large

Positive

40% - 60%

Moderate

Small

> 60%

Small

Large Negative

An examination of the problem indicators can help direct your management efforts in tough times. First, examine the serious problem column. Any problem area that has two or more serious problem values circled should be addressed immediately. Problem areas with one serious problem measure should be evaluated soon afterwards. Next, examine those problem areas that have more than one caution measure circled. These are areas that have room for improvement, and if addressed now should improve your long-run performance and long-run survival. Last, look at each problem area where you’ve circled more than one value that is not a problem. Pat yourself on the back and try to capitalize on these strengths.

You now know if liquidity and/or solvency are “red flags” for you. How quickly these red flags show up in your beef cow business during the down side of the current beef price cycle depends on (1) the productivity of your beef cow herd, (2) your cost control program, and (3) the debt structure associated with your beef cow herd. You now need to formulate a management plan for removing any “red flags” that you’ve identified.

Resources

Record Keeping and Accounting (Colorado State)

The National Drought Mitigation Center | 3310 Holdrege Street | P.O. Box 830988 | Lincoln, NE 68583–0988
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