Don’t Confuse Cash Flow with Profit
As dairy producers make financial decisions, the terms profitability and cash flow are often used interchangeably. However, confusion between the two can cause producers to make decisions that are not in their best long-term profit interests.
According to Dairy Financial Consultant, Gary Sipiorski, cash flow addresses only the cash that a farm deals with.
“Think about it as what goes into the checkbook and what comes out,” he says. “This includes milk income, livestock sold, grain sales and any other income. All farm expenses are included such as labor, family living draws and all the other on-going farm expenses, principal and interest payments.”
Larry Tranel, a dairy field specialist with Iowa State University Extension, concurs with Sipiorski and says cash flow has the goal of having enough money available in a timely fashion to pay the bills on time.
Cash flow does not address depreciation, accrual adjustments regarding inventory changes of feed stored, cattle, prepays and bills not paid.
Sipiorski says that from this standpoint, if the bills are paid and there is money in the checkbook the idea is ‘the farm is making money.'
UNDERSTANDING FARM PROFIT
Profit can be defined as an accrual adjusted Income Statement, which means all of the income is and farm expenses are accounted for. It then shows inventory adjustments for feed, livestock, prepayments, outstanding bills, etc.
“With feed values the same from one balance sheet to the other, if there is $75,000 more feed inventory, that is a positive accrual adjustment on the income statement and it shows up as more profit,” Sipiorski explains. “If there is $75,000 less feed on hand, that is a negative adjustment with a bottom line of less profit.”
Interest is used as an expense in an Income Statement, however principal is not. Economic depreciation is included. Sipiorski says hopefully the amount of depreciation is at least equal to the principal paid back.
“If there are a lot of negative accrual adjustments of feed, cattle, and outstanding bills, the cash flow on the farm may look good. However, the real profitability will look far different,” he says. “After several years of operation, this can be hugely different in farm financial progress.”
Tranel says that cash flow does not show a profit, does not always correlate to profit and contains many numbers that have little or nothing to do with profit.
“A less profitable farm might cash flow easier due to lower debt load or a spouse’s off-farm income than a really profitable farm that has a lower production cost, a higher return per unpaid labor hour and a higher return on assets,” he says. “Cash flow is an important tool, but it needs to be kept in perspective.”
MONTHLY CASH FLOW
Dairy farms generally have an even month-to-month cash flow other than in the spring and fall when there are higher expenses. Sipiorski recommends doing a farm projection cash flow before the new year begins.
“If there are months when the monthly cash flow is short, a lender meeting should be held at that time to ask for a line of credit (LOC) to fill in the needs for certain months,” he says. “Providing the farm has a good ‘credit rating’ with the lender, this should not be a problem getting a LOC.”
If the farm is not in good standing with the lender and no LOC is allowed, Sipiorski says the farm has to go without and hopes that they still can cash flow.
“What generally happens here is bills are not paid and the suppliers end up holding the credit,” he explains. “They in essence become the lender with 18% interest vs. 6% from the lender.”
Sipiorski cautions that a supplier will only go so far and that this can make operating difficult for farms to get inputs when needed.
Tranel concurs and says that profitability is a common goal with often an uncommon understanding.
“As with most things in farming, there is often a wide range of profits and an even wider range of how a producer understands profits,” he says. “Many confuse cash flow with profits, others compare partial analysis with full costs of production.”
By KAREN BOHNERT
September 14, 2022