During the last decade, my high-profit Integrated Resource Management (IRM) cooperators demonstrated that the herds that best survive the market's volatile price swings are those with high economic efficiencies. They proved that the key to long-term beef cow profits is to increase the economic efficiency during the good times in a cattle cycle.
In turn, this gained economic efficiency can be used to lower the unit cost of production. In turn, these lower costs of production can be used to build a financial reserve during the good years to help the operation better weather the next price downturn.
The obvious question is: “Given today's international trade restrictions due to bovine spongiform encephalopathy (BSE), how does a beef cow producer do this?”
First, I'll discuss how high-profit IRM cooperators managed their way through the 1990s beef price cycle. Then, we'll discuss how high-profit, beef-cow producers integrate economic analysis, financial analysis and cash-flow analysis to manage their way through the volatile price cycle.
Special Management Actions
The first management action beef producers should take to increase economic efficiency and build a financial reserve is to assess their herd's current economic efficiency. There are three recommended “green-flag/red-flag” herd business management assessment tools that producers should faithfully utilize. The three tools should be used annually to monitor the business side of their beef cow herds as they progress through a complete beef price cycle.
The first is a net-cash-flow account. It's designed to answer the question: “Are my beef cows generating a positive cash flow or is my herd being subsidized by other sources of cash flow?”
The second tool is a net-value-added account. Often referred to as the economic analysis, it's designed to answer the question: “How much added economic value did my family generate by running beef cows this year?”
The third assessment tool is the net-financial-return account. Often referred to as financial analysis, it answers the question: “Are my beef cows adding equity to my family business or are my cows consuming family equity?”
The bottom lines from these three business management accounts become the herd's annual, key, business-performance benchmarks.
- Net-Cash-Flow Account
This account measures the net cash flow associated with the beef cow herd. It's based on the total cash income generated by the beef cow herd, minus the cow herd's total cash outflow.
Besides the herd's obvious cash costs, it also includes the cash cost of growing farm-raised feeds and forages fed to the beef cow breeding herd, the cash costs of debt service (interest and principal payments) directly associated with the beef cow herd, and the family living draw assigned to the beef cow profit center. Depreciation on cows and/or equipment are not considered cash costs and aren't taken into account in the net-cash-flow account.
- Net-Value-Added Account
The net-value-added account measures the earned net returns to unpaid family and operator labor, management and equity capital. These three are the only resources contributed by the farm or ranch family.
The resource costs in this account are based on farm-raised feeds fed to the beef cows priced at fair market value (opportunity costs). The pasture cost is valued at the going local rental rate. Assets are valued at market value. Actual interest paid on borrowed money, and non-cash depreciation on the beef cow assets, are all included. Principal payments and family living are not part of the net-value-added account.
- Net-Financial-Return Account
The net-financial-return account is the traditional accounting measure of business profitability. It's based on assets valued at book value (cost minus depreciation taken to date), costs of producing farm-raised feeds, actual operating costs of pastures grazed, and actual interest paid on borrowed money.
Land is valued at acquisition cost, not current market value or opportunity cost. If the land is paid for, there is no land investment cost. Generally-Accepted Accounting Practices are used to generate the net-financial-return account for the beef farm or ranch.
Ideally, the three, key herd economic signals described above should be established during the good years of the beef price cycle. This way, benchmark trends are in place before the cyclical downturn. Any deviation from the benchmark trends can be used as early warning “red-flag” business signals for a beef cow herd as prices turn downward. That's the real power of these benchmarks.
My past IRM experience suggests that beef farmers or ranchers who recognize their beef cow herds' red flags the earliest, and take immediate management action, best survive the beef price cycle's downturns.
How The Red Flag-Green Flag System Works
North Dakota has generated herd assessments for IRM cooperators for one complete cattle cycle. When beef prices were high, as in the early 1990s, the typical beef-cow business generated a positive net cash flow, a positive net value added, and a positive net financial return. All these are green flags.
As the beef price cycle turned down in mid-decade, a distinct order of red flags started showing up. In the downturn's first year (1994), some herds, but not all, generated the first, red-flag signal for net cash flow. Typically, the other two business benchmarks were still sending positive green-flag signals.
This first red flag — net cash flow — indicated the beef cow herd was no longer generating its own cash-flow needs. We now know these early, net-cash-flow red flags were an early signal of more financial problems to come. At the time, we weren't so experienced with these flag signals.
As beef prices continued to lower in 1995, we began seeing the second red flag — signals from the net-value-added herd assessments. These suggested the beef cows now were not paying market price for all the resources consumed.
For example, the beef cows were paying less than the local market would have paid for farm-raised feeds. The net-financial-return benchmarks, however, were typically still positive, suggesting the good news was that these herds were not consuming equity.
As beef prices continued to drop in 1996, the net-financial-return benchmarks on some herds turned negative and sent the third, red-flag signal. This red flag indicated these ranchers were consuming equity capital and their long-term survival was in jeopardy.
Note the order the red flags appeared in this downturn. The first red flag was negative net cash flow. The second was net-value added. The third was negative net financial returns.
The net-cash-flow red flag was typically received two to three years before the long-term survival of the business came into jeopardy. The key to the financial performance of these businesses was early detection, followed by immediate corrective action.
Astute managers responded to the early red flags and took corrective action improving economic efficiecy before the business deteriorated further. Those without these red-flag benchmarks waited for their banker to detect financial stress. By that time, it typically was too late to improve economic efficiency of the beef cow herd.
A manager who waits for the banker to raise the first, red-flag signal is asking for financial trouble. A beef cow manager must read the red flags earlier than his banker.
When beef prices started back up in the 1997-2000 time period, the net-financial-return flag turned green first. The net-value-added flag turned green second, and the net-cash-flow flag turned green last.
Without a financial reserve, some of these herds studied had three years of negative net cash flow, and a few had up to five years. Typically, three years of negative net cash flow will substantially weaken the financial structure of a beef business. I can almost guarantee that five years of negative net cash flow ensures a beef cow herd won't survive.