Like canaries placed in a mine to provide early warning of danger to workers, there are three “green-flag/red-flag” herd business management tools that ranchers should consider as they take their beef cows through the 10- to 12-year cattle cycle. All three are specifically designed for the beef-cow profit center, and their bottom lines become a beef cowherd's key economic benchmarks. They include:
- Net-cash-flow account,
- Net-value-added account and
- Net-financial-returns account.
These three key economic benchmarks must be established during the good times of the beef price cycle so benchmark trends are in place before the cyclical downturn. Deviations from the benchmark trends can then be used as early-warning “red-flag” business signals as prices cycle down. Producers who recognize their herd's red-flag signals early on can adjust to better weather the price downturn. Let's look at each in more detail.
The annual net-cash-flow account is based on the cowherd's direct cash costs. This includes growing farm-raised feeds and forages for the cows, servicing debt (interest and principal payments) and drawing family living from the beef cowherd profit center. Cow and equipment depreciation aren't cash costs and aren't considered in the cash flow analysis.
Net-cash-flow is the business's cash flow bottom-line-benchmark and is used to answer the question: “Are my beef cows generating a positive cash flow, or are my beef cows being subsidized by other sources of cash flow?” If the beef cows are generating a positive net-cash-flow, the benchmark is a “green flag;” if they're generating a negative net-cash-flow, this benchmark is a “red flag.”
It's particularly critical that a multi-year, net-cash-flow benchmark trend be established early in the expansion phase of the cattle cycle. Early deviations from this trend line provide an early signal when cash flow conditions start to deteriorate. The earlier the signal, the better.
The net-value-added account is based on farm-raised hay and feed priced to the beef cows at fair market value (opportunity costs), assets valued at market value, actual interest paid on borrowed money, and non-cash depreciation. Principal payments and family-living draw, on the other hand, aren't part of economic costs.
Net-value-added and net-cash-flow are two distinctly different business management tools. Net-value-added is the bottom-line benchmark used to answer the question: “How much added economic value did my family generate by running the beef-cow herd?” It is the dollar net returns the ranch family earned from their unpaid family and operator labor, management and the family's equity capital contributed to the beef-cow profit center. These are the only three family resources contributed to the beef-cow profit center by the farm or ranch family.
Positive net-value-added benchmark profits reflect the magnitude of the family's earned net income for its unpaid family and operator labor, management and equity capital. A negative economic net-value-added benchmark, on the other hand, implies the family received no economic payment for its three resources contributed and, in fact, the beef cows didn't even pay market price for farm-raised feeds and/or pasture grazing provided.
A rancher doesn't need to add value to the family's resources consumed by the beef cows each and every year, but a negative net-value-added benchmark in any one year is a red flag that needs management's attention. Repeated years of negative net-value-added benchmarks from the beef-cow profit center can financially jeopardize the overall business.
The third tool is the net-financial-return account, which is based on assets valued at book value (costs minus depreciation taken to date), costs of producing farm-raised feeds, cost of pastures grazed, and actual interest paid on money borrowed for capital assets. Land is valued at its actual acquisition cost and not at current market value or opportunity cost. If the land is paid for, there is no land cost.
The net-financial-return is the bottom-line benchmark used to answer the question: “Are my beef cows adding equity to my family business, or are my cows consuming family equity?” A negative net-financial-return is a red flag that equity capital is being consumed. This must be immediately rectified or the total business may quickly fail.
Last cycle's lessons
Using data generated for North Dakota cooperator herds during the complete cattle cycle of the 1990s, let's review what was learned from these Integrated Resource Management herds' green-flag/red-flag assessments. When beef prices were high, the typical beef-cow business generated a positive net-cash-flow, a positive net-value-added and a positive net-financial-return. During the good times, all herd assessment benchmarks for typical beef cowherds were sending green-flag signals.
As the price cycle turned down in middecade, a distinct order of red flags appeared. In the first year of the downturn (1994), some herds generated net-cash-flow red-flag signals. Generally, these were ranchers using borrowed capital.
Typically, the other two business benchmarks were positive and sent green-flag signals. We now know the early net-cash-flow red flags were a signal of more financial problems to come.
As beef prices continued lower in 1995, red flags in the net-value-added herd assessment began appearing. The net-financial-return benchmarks, however, typically were still positive and sending green-flag signals.
As beef prices continued to fall in 1996, some herds' net-financial-return benchmarks turned negative. The other business measures were also sending red-flag signals. This third red-flag indicator implied these operations were consuming equity capital, and their long-term survival was at stake.
It's significant to note the order in which these red flags appeared in this downturn. The first to pop up was negative net-cash-flow, followed by negative net-value-added economic-returns, and then negative net-financial-returns. The net-cash-flow red flag typically was received 2-3 years before the long-term survival of the business came into jeopardy. The key to the financial performance of these businesses was early detection and immediate corrective action.
Operations without access to these red-flag benchmarks waited for their banker to detect financial stress. By that time, it was typically too late.
A beef-cow manager needs to read the red flags earlier than his banker. A banker's responsibility is to protect depositors' loan security, not ensure the financial health of a ranch business. A manager who waits for his banker to raise the first red-flag signal is asking for financial trouble.
When beef prices started back up in the 1997-2000 period, the net-financial-return flag turned green first, followed by the net-value-added flag and lastly net-cash-flow. Without a financial reserve, some herds had three years of negative net-cash-flow and a few had five years.
Typically, three years of negative net-cash-flow will substantially weaken the financial structure of a ranch business. We can almost guarantee that five years will ensure a beef cowherd won't survive the next cattle cycle. Once stressed, a business may never recover.
Beef producers need to cash flow each and every year. This means no net-cash-flow red flags. Otherwise, you'll be talking to your banker about some changes, which may include asset liquidation.
A beef cowherd, on the other hand, doesn't need to add value to the family's resources each and every year. However, a negative net-value-added benchmark (i.e., net-value-added red flag in any one year) signals the need for management attention. Negative net-value-added benchmarks over multiple years have the potential to snowball into a major total business financial problem.
A negative net-financial-return benchmark in any one year implies equity capital is being consumed. This is serious and must be immediately turned around or financial survival is in jeopardy.
Harlan Hughes is a North Dakota State University professor emeritus. He lives in Laramie, WY. Reach him at 701-238-9607 or [email protected].