How does your dairy manage financial risk?
Dairy farms are subject to many types of risks, including market and price, production, human resource management, environment and policy. With the volatility of farm milk and feed prices in recent years, dairy farmers have made better use of risk management tools such as insurance and futures and options. It can be difficult to set goals and assess the performance of risk management activities. Let’s take a look at some of the issues with identifying risk and setting risk management goals on a dairy farm.
There are many business and personal aspects that determine the risk position of a farm operation. Perhaps the easiest is the financial situation. Using accrual-adjusted income statements and balance sheets at market values, dairy farm managers can assess the solvency and liquidity of the operation. Not only is this information useful for evaluating performance, it is also closely related to the metrics lenders use to assess credit risk and determine loan viability.
There are many measures of solvency, but they all measure the relative amount of equity in the operation. Since asset value minus debt equals equity, knowing two of these values means we know the third.
One ratio that indicates the solvency position is the value of farm debt in relation to assets – again, most accurate with assets valued at the market rate. This is the portion of farm assets that is owed to a lender, so higher values indicate a higher risk of insolvency.
In recent years, lenders have wanted this value to stay below 60 percent, with some wanting less than 50 percent. The closer agricultural values get to this level, the risk management activities to ensure that no additional debt is required are even more important.
Likewise, liquidity can be measured in several ways, but the main problem is having funds available to pay the bills. The current ratio is defined as the value of current assets divided by the value of current liabilities.
Current assets are those that are in cash or can be easily converted to cash, including stocks of crops and feed and market livestock. Current liabilities are debts that fall due in the following year, including accounts payable, operating loans and the current portion of term debt.
While a farm can also sell medium to long term assets to pay bills, selling these assets has negative implications for future production. A higher current ratio indicates that more assets are available to pay debts. Values less than 1 mean that there are not enough assets at the time to pay the debts that will fall due and that accommodations, such as an operating loan, will likely be required. Lenders would like the current ratio to be 2 or more.
However, keep in mind that there are opportunity costs to having too much cash. In other words, holding additional cash will help pay unforeseen bills, but at the cost of using those funds in potentially profitable investments. Again, the lower the current ratio, especially if it approaches 1, the more important it is to minimize the likelihood of a shortfall that will put a strain on the farm business.
Using these solvency and liquidity measures, farm managers can assess how much they can afford to borrow until they reach the trigger point or if they might need to generate income. more cash. This information is useful for understanding the ability of the farm business to absorb a bad year in terms of milk and / or feed prices. The assessment of the financial situation of farms does not reveal the desired action. However, this may indicate that risk management is necessary.
RISK CHANGES WITH AGE
The objectives of an agricultural market and price risk management program will depend on many factors unique to the farm management team and the financial condition of the operation. Personality, age and preferences affect risk management goals.
Attitude to risk can change over time and with the amount of money involved. As retirement approaches, people tend to be more careful with their financial decisions because they have less time to recover from a disaster.
Past experiences also influence risk preferences. Farm managers who lived through the recession and agricultural crisis of the 1980s often have a very different outlook than those who started their careers in recent decades. Together, the financial situation of the operation and risk preferences can help set goals. Goals may include maximizing worst-case returns or ensuring a minimum return to cover required expenses.
THE TOOLS DELIVER THREE RESULTS
There are many risk management tools available, but they typically do at least one of three things:
- Reduce negative impacts on results
- Improve risk-taking capacity
- Maintain flexible decision making
Insurance and government programs are tools that reduce impacts. Maintaining liquidity and access to credit improves risk-taking capacity. Spreading marketing maintains decision flexibility.
Registration is currently open for the Dairy Margin Coverage (DMC) program. We know 2019 will result in DMC payments that will cover more than the premiums at a coverage of $ 8.50 per cwt. or more. While a farm can cover 5 million pounds of actual production history at $ 9.50 per cwt, payments are currently estimated to be around $ 20,000 net of premiums.
Thus, one approach to risk management today is for dairy farm managers to assess the potential help of CMD and determine whether increased protection is required or desired. If so, protection of dairy income, livestock gross margin for dairy products, cooperative tools including futures, as well as futures and options can complement risk management activities. existing.
Finally, evaluating the results of risk management programs can help adjust goals and expectations. One of the problems with assessing risk management performance is that stocks are always ‘second rate’ in the sense that if, for example, milk prices go down, then more should have been done. , and if milk prices improve, then the cost of risk management has gone for naught.
Regret is a powerful emotion. Psychologists have found that people often prefer to do nothing and something bad to happen rather than act with the same result. However, consider that not making a risk management decision is making the decision not to be protected.
The long-term goal of risk management programs may be to minimize the likelihood or consequences of low economic returns. This will mean costs will be incurred and returns can sometimes miss the top of the market. The extent to which this compromise is acceptable depends on the objectives and preferences of the farm manager.