5 key financial analyses a dairy farm should consider

Alternative buyers’ purchasing power will be tested and will likely lead to price adjustments in the dairy market. Grain and oilseed market prices are reaching near decade highs. This is a combination of lower supply from adverse weather in key growing areas and strong demand which is expected to remain firm in Q1 of 2022.

In Q3 2021, other nutritional feed ingredients such as vitamins and amino acids, offered at relatively higher prices (average 5-10%), mainly due to shortages and higher energy production costs, mean tighter profit margins for dairy farmers. The cost per litre of milk produced has increased significantly. Dairy demand in some markets and categories will be tested given ongoing consumer cautiousness, environmental awareness and affordability issues.

Furthermore, it is expected that more added-value dairy products (organic products and products with a low CO₂ footprint) will be market premiums and promoted to supermarkets of developed countries.

Below are 5 key financial aspects for sustainable dairy operations to consider.

1. Liquidity analysis

Liquidity remains very important for farmers worldwide as it can keep them away from negative cashflow after paying all financial obligations. From a farm balance sheet, you can easily measure liquidity from the current ratio. You can get this ratio by dividing total assets by total liabilities. This ratio compares aspects changing on a yearly basis and should be anything higher than 1.5. Working capital is also critical when considering the expansion of dairy units. Total farm assets minus total farm liabilities divided by total expenses in percentage should be greater than 50% for farms expanding, or around 25% for farms kept stable.

2. Solvency analysis

Debt-to-asset ratio compares total farm debt to total farm assets. This ratio represents the bank’s share of the business. The higher this ratio, the more risk the farm has. A high ratio may limit the ability to borrow additional money. A debt-to-asset ratio up to 30% looks ideal for established farms, while most financial institutions prefer a ratio below 60% for farms under expansion procedure.

3. Profitability analysis

To survive challenging times, a business must generate a profit. Farm profitability refers to a farm’s ability to generate a net return above expenses from the use of its own resources. Net Farm Income (NFI) from operations is well calculated by taking the total revenue (gross cash income) less the operating expenses and depreciation and adding or subtracting the change in inventory, market animals, and accounts receivable or payable.

Operating profit margin (NFI + interest paid – operating expenses / total revenue) and rate on Return on Assets (ROA) are measurements that lenders are putting greater emphasis on. ROA (NFI + interest paid – operating expenses / total assets) measures the amount of profit generated per euro of asset. A business plan that can show how the farm improves on these ratios over time will show the ability of the business to grow and be successful.

4. Financial efficiency

Financial efficiency measures capital efficiency – how intensively a business’ assets generate gross revenues. It is calculated by the asset turnover ratio which is total revenue divided by total assets. This value when multiplied by the operating profit margin equals the return on total farm assets. Well-established dairy farms have financial efficiency greater than 35%.

5. Repayment capacity

Although repayment ability is not considered as a financial performance measurement, it could be a critical point that a farm loan may need restructuring. Term-debt coverage measures the repayment capacity of a farm – the ability of a farm to pay all short-term and long-term loans. The term-debt coverage ratio should be positive – the higher the ratio, the better. Banks require a term-debt coverage of at least 1.25 to consider a business plan viable.

If the Covid-19 pandemic taught us all involved in the dairy industry something, it is definitely to not underestimate the power of a budget. We are facing several important decisions every day, including the impact on the financial bottom line. We need to use farm financials as a tool to impact our daily decisions associated with dairy operations and management.

Farm managers need to be thorough, realistic and able to forecast changes in order to keep a dairy business sustainable. In my opinion, this is how modern farm units should operate and in parallel, they should increase direct communication with other intermediates in the sector, including dairy factories.

References available on request.