Grazing’s potential: expansion’s effects on cash flow (Research Brief #31)
Posted September 1998
All farm types examined here, particularly the low and medium investment farms with high levels of debt, may find an expansion involving sweat equity to be the best option for them.- Rick Klemme
Grazing-based dairy farmers considering expanding their herds and constructing labor- saving parlors need to consider the expansion’s effect on profitability carefully. (See CIAS Research Brief #30.) However, a UW team of faculty and staff also stress the need to consider existing debt, future cash flows, and the level of pending investment they face. This team found that expansion can pay for a modified seasonal calving system using a labor-saving parlor (thereby improving the farmer’s quality of life and increasing future options). But the net cash flow depends on the farm’s existing debt and pending investment situations.
The UW team studied costs, profits, and cash flows on scenario farms at a base level of 70 cows, and expanded levels of 100 and 125 cows. At the expanded levels, the farmers built a New Zealand style swing-over parlor and employed a modified seasonal calving system. The team compared how well farms with three levels of initial building and equipment investment could shoulder the expansion. They compared how profitable three farms-a low investment farm, with $62,000 invested in buldings, a medium investment farm, with $112,000 invested in buildings, and a high investment farm, with $165,000 invested in buildings-would be with an expansion. The high investment farm was the most profitable after the expansion, because existing facilities could be used. And 125 cows provided the highest return on all three of the farms.
The research team included Rick Klemme and Bimal RajBhandary of the Center for Integrated Agricultural Systems (CIAS), Gary Frank, a farm management specialist with the Center for Dairy Profitability, and Larry Tranel, Iowa County extension farm management educator.
To determine each farm’s ability to cash flow the expansion, team members assumed that all capital for the new investments would be borrowed and added to existing debt. They calculated the number of years required to pay all debts. And they used three levels of existing debt for the farms: $50,000, $100,000, and $150,000. All loans were assumed to have a ten percent interest rate.
According to Frank, “A farm must usually be able to repay all existing debt in ten years or less, before pending investments, in order for it to have a successful long-run cash flow.” All three farms started out with a repayment period of less than ten years for each of the debt level assumptions (see table below, 70 cows). Repayment periods generally increase with expansion, and in many cases go beyond ten years.
The low investment farm has an acceptable cash flow for expansion at only the $50,000 level of existing debt, and the medium investment farm at up to $100,000 of debt. The high investment farm has an acceptable cash flow at all debt levels. The high investment farm has a better chance of a successful expansion, even at high debt levels, if the existing assets can be successfully used in a grazing expansion.
|Years to repay new investment and existing debt|
The financial situation of the farms has another dimension: pending investments. As the farm equipment and buildings age, additional investments in the form of maintenance and replacement are needed. The older the equipment, the higher the amount of these pending investments. “Including pending investments in the analysis brings the situation much closer to the reality farmers face,” points out Klemme. The team members assumed that at 70 cows and existing facilities, the farms have $120,000 of pending investments over the next ten years; after the 100-cow expansion, $60,000 of pending investments; and after the 125-cow expansion, $40,000 of pending investments.
Farmers with existing debt of over $150,000 and $120,000 of pending investments in the next ten years are in a tight spot, particularly at lower levels of current investment. “All farm types examined here, particularly the low and medium investment farms with high levels of debt, may find an expansion involving sweat equity to be the best option for them,” concludes Klemme. The table below shows that when pending investments are included, the debt repayment periods exceed 10 years at the $100,000 and $150,000 levels of debt on the low and medium investment farms at all levels of cow numbers. At the $150,000 debt level, the repayment period is at or above ten years on the high investment farm at all cow levels.
|Years to repay new investment and existing debt with pending investment considered|
Increasing milk production
The researchers assumed milk production of 15,000 pounds per cow annually, but they wondered what effect increased milk production would have on debt and cash flows. “This is the easy way to a better financial situation on paper, and should be carefully interpreted because higher production comes with anticipated costs that we included, and maybe some unanticipated costs,” says Frank. At a 17,000-pound herd average, with associated higher expenses, the farm generates positive profits on the three farms and at all cow levels, leading to reduced repayment periods. At 70 cows, repayment periods, including pending investments, are over ten years only at the $150,000 level of existing debt.
Consideration of existing debt and pending investments brings the financial model of expanding a management intensive rotational grazing dairy closer to farmers’ real situations. When pending investments are included, repayment periods increase to much longer than ten years in many cases. “This is a warning signal that the long-term financial stability of the farm may be in jeopardy, and the expansion would either be not allowed by the banker or be very risky,” Frank observes.
“From both short-term and perhaps long-term net income and cash flow perspective, the best thing to do appears to be increasing the production level of the cows,” says Klemme. Profits are higher at a 17,000-pound herd average, reducing repayment periods and providing a stronger financial base for an expansion.
Farms with high debt and low current investment will have a difficult time expanding in a typical way, and may have to depend on sweat equity to bring the cost of expansion within their reach. Another short-term solution in this situation is to look to lower capital cost options. For example, installing a flat barn parlor would help speed up milking time and may reduce the amount of bending required of the farmer.
“Farmers considering an expansion with a parlor should contact graziers who have completed such an expansion to gain insight on their experiences and learn more about what they can afford in their expansion,” suggests Klemme.
Contact CIAS for more information about this research.
Published as Research Brief #31