Price volatility is the new normal in the dairy industry, so how dairy farmers address the industry risks can determine their level of success, said Dr. Christopher Wolf, professor of Agriculture, Food and Resource Economics at Michigan State University.
“There are a lot of different definitions of risk, but I think the most simple one is that risk refers to the bad outcomes that can occur because of uncertainty,” Wolf said.
Dairy producers work with and through risks on a daily basis and also witness the effect risks can have on a farm’s financial situation.
“We have a lot of different sources of risk in dairy farming. If you’re a dairy farmer, you have got price risk on both sides for output with milk and input with costs associated with feed and labor. Production is also a risk, especially this year with the drought,” Wolf said.
Producers also face financial risks and risks with employees and policies. “Financial risk refers to your solvency position. Do you have enough equity to stay solvent? Do you have enough liquidity to pay the bills when they come? Human resource risks are becoming increasingly important as we have more hired labor and as farms get bigger,” Wolf said. “On the other hand, policy has to do with international policies, trade agreements, and domestic policies like the Farm Bill and environmental policies.”
Throughout the risk assessment process, producers face a level of uncertainty and predictability, instability and stability, and inadequacy and adequacy.
“Predictability looks at what degree you can predict the price in the market. With stability, you know you will have seasonal movement and stability is not always a good thing. Adequacy is the most important. You need to consider is the price adequate enough to make a return,” Wolf said.
Some producers may not see risk management as a valuable asset in the success of a farm operation, but it can help make effective long-term decisions.
“Risk management is important because it helps you, as a dairy farm manager, prioritize where your efforts should be. This increased awareness could possibly help you make better decisions for both operational dairy management and strategic long-run decisions, like should we be growing more of our own feed or should we be sending our heifer enterprises somewhere else,” Wolf said.
Utilizing the proper financial statements can assist in establishing risk management practices. “If you look at the balance sheets and income statements and have an accrued adjustment situation with the change in inventory and you have up to two years earlier, you are going to see a problem coming faster than those who are just doing cash accounting. By anticipating potential events, you become more agile and are able to better respond and be proactive in a risk situation,” Wolf said.
When assessing a farm’s risk situation, producers need to think about the low farm milk price, high purchase feed price, and the effect that can have on cash flow, liquidity situation, and solvency, said Wolf.
“You can think of this in terms of ‘how large of a loss can you afford?’ You have to determine how much equity you have and how much you need. What is your maximum allowable decline and what is your annual cash carryover,” Wolf said.
There are generally three ways to handle risk on a farming operation, said Wolf. “You can shift risk, which means to use contractual arrangements, like insurance or hedging. You can reduce risk. You can do lots of things everyday that reduce risk: you can reduce the risk of mastitis through your milking procedure, through repairs and veterinary medicine. You can reduce risk by changing the enterprises you grow and perhaps find some less risky enterprises. Finally, if you are not doing anything, you are self insured,” Wolf said.
Throughout the risk assessment process, there are three dimensions of a farm’s financial performance. “There is profitability, which is generating enough income to cover your expenses. Then there is solvency or possessing enough assets to more than cover your liability. A farm is solvent if they have positive equity or net worth. And finally, liquidity or cash flow, which is having money available when the bills come due to pay. You can have a problem in any one or all three of these dimensions,” Wolf said.
These three dimensions can be tracked using balance sheets or a list of all of the liabilities and assets on the farm. Solvency is measured as the debt to asset ratio or farm liability divided by the farm assets, and generally this number should be below 0.6. The higher this number gets, the riskier it becomes and that can have a direct effect on the expenses too due to higher interest rates. On the other hand, liquidity is the current farm assets divided by the current farm liability and should be greater than 2.0.
“Price risk management is often the second best solution, in hindsight, but it depends on the risk attitude of the management team,” Wolf said.
The management team can assess risk utilizing stress tests using cash flow statements from three to five years along with a production cash flow budget with most likely milk price and feed costs, worst case scenarios with potential lower milk prices and higher feed costs, and an examination of the solvency position of the operation, said Wolf.
In the past, producers focused on buying feed as the preferred mode for feed grain, but that is not always the case now. “You need to consider how much you can pay in land rent to avoid feed purchases and that includes land rent and non-land rent costs like seed, fertilizer, pesticides, drying, storage, crop insurance, machinery, fuel and oil,” Wolf said.
Although producers have historically treated input and output costs as separate issues, Wolf recommends that producers look at them together. “You need to figure out what your financial position is because that is what is going to help you form your marketing plan and determine how you move from there,” Wolf said.