The capital required to remain competitive in the milk production industry has increased dramatically in recent years. For example, studies at Washington State University indicate the amount of capital needed to establish a modern, typical-sized dairy enterprise increased from $269,146 in 1976 to $824,585 in 1992. Further, due largely to the continuing adoption of more capital intensive milking, feeding, and waste handling systems, coupled with the additional consolidation of milk production into fewer and larger operations, future capital requirements for the individual dairy farm will continue to rise. These soaring capital needs have encouraged many dairy farmers to rely heavily on debt. Managing this debt effectively is essential for a successful dairy business.

Effective debt management is basically a matter of assuring that debt: (1) contributes to business profitability, that is, it returns more than the cost of borrowing; (2) can be paid back according to the repayment terms available from lenders without disrupting the business; and (3) is consistent with the producer's willingness to accept the added risk associated with debt financing. These issues often prompt dairy farmers and their credit sources to ask, "How much capital debt can a cow carry?"

While this key question can be answered by rules of thumb or a review of published farm record summaries, they often seriously misrepresent the amount of debt appropriate for a particular producer. The appropriate debt level depends on many factors, including cow productivity and profitability, interest rate on the debt, debt repayment terms, and the producer's feelings about financial risk. These factors often differ widely between producers. Consequently a sound estimate of debt carrying capacity for an individual producer should rely on a financial analysis of the producer's business.

This publication presents an analysis tool that dairy farmers, lenders, and financial consultants can use to estimate per-cow debt carrying capacity. A worksheet outlining the required data and analysis procedures is included, and an example illustrates how to use it.

Basic assumptions underlying the worksheet are:

1.	The dairy enterprise is the basis for determining debt carrying capacity. Depending on the revenues and expenses included in the analysis, the dairy enterprise may be restricted to only milk production or may include heifer raising, feed produced to support the enterprise, or breeding animals raised for sale.
2.	Debt carrying capacity is defined as the maximum amount of debt supported by dairy enterprise profitability and cash flow. Considerations other than profit and cash flow (e.g., risk) may result in actual debt levels considerably below the maximum debt carrying capacity.
3.	Average annual profit and cash flow, along with level annual principal and interest payments, are used to determine debt carrying capacity.
4.	Debt carrying capacity refers only to capital debt. Capital debt, or term debt, is used to purchase capital items, inputs with a productive life of more than one year. Thus, capital debt is used to finance such assets as machinery, vehicles, cows, buildings, and land. A repayment period of more than one year is typical for capital debt. In contrast, operating debt is used to purchase inputs that will be used within one production cycle, usually a year, and is therefore generally expected to be paid back within one year. The worksheet does not include operating debt in the estimate of debt carrying capacity.

The accompanying worksheet requests the information and indicates the calculations needed to estimate the per-cow capital debt carrying capacity for the dairy enterprise. Its use can best be illustrated by an example.

Example

H.O. Stein owns and operates a 200-cow dairy. Herd replacements, hay, and grain are purchased and silage is produced on the dairy. Already existing capital debt used to purchase heifers and replace facilities, equipment, and vehicles is $95,000. Annual debt service on that debt is $20,600, or $103 per cow. Due to problems with the waste handling system a substantial investment to improve and expand the system is under considerations. It is likely that considerable debt will be used to finance the investment. H.O. Stein is concerned about how much additional and total capital debt the dairy enterprise can handle. Completion of the accompanying worksheet will address that concern and help analyze the potential waste handling system investment. Worksheet data are annual projections reflecting the most likely values for the next three to five years.

Lines 1-6 compute gross revenues to be realized from dairy enterprise sources. As indicated on line 6, these revenues sum to $2,540 per cow. Assuming annual sales of 21,000 pounds of milk (line 1) and an $11.00 per hundredweight milk price, net of marketing and transportation expenses (line 2), revenues from milk sales are $2,310 (line 3). Cull cow sales, net of marketing expenses, amount to $161 per cow (line 4). That estimate is based on a 30% annual herd turnover, 2.5% death loss, 1,300-pound cow and a net selling price of 45¢ per pound, that is, [(0.30 - 0.025) x 1,300 x 45¢]. Revenues from heifer and bull calves are recognized on line 5. Since H.O. Stein is selling all heifer and bull calves, these annual calf revenues amount to $69, which are based on 0.48 heifer and 0.48 bull calves valued at a few days of age at $50 and $100 per head, respectively. If the producer is keeping heifer calves for replacements and wants to include that activity in the milk production enterprise, the value of retained heifer calves should not be included on line 5. Report revenues from these animals on line 4 when they are culled from the herd. Further, if heifer calves are retained and the producer wants to separate heifer raising from the milk production enterprise, include the value of retained calves at a few days of age on line 5.

Annual feed expenses are $1,278 per cow (line 7). These expenses reflect the price paid for purchased hay, grain, and minerals delivered to the farm. Also, since H.O. Stein wants to estimate the debt carrying capacity of the milk production enterprise separately from feed production activities, a market value adjusted for delivery costs has been placed on homegrown silage. If the desire is to include feed production with the milk production enterprise, do not value home-grown feed on line 7; instead, feed production expenses should appear on line 8. Include feed consumed by replacement heifers on line 7 if you want to combine the replacement and milk production enterprises. However, if debt carrying capacity is to be based only on the milk production enterprise, do not include replacement heifer feed expenses on line 7.

Enter annual other expenses on line 8. Expenses to include here are hired labor, hired management, veterinary, medicine, repairs, fuel, bedding, lease payments, supplies, testing, insurance, property taxes, accounting, legal, utilities, dues, and interest on operating capital. The individual cow's share of these expenses is $714 for the example operation. Do not include depreciation, interest on capital debt, principal payments, and family living expenditures in the estimate. These items will be considered in later phases of the analysis. If replacement heifers are raised on the farm or custom raised and debt carrying capacity is to include this as part of the milk production enterprise, heifer raising expenses (excluding feed) should be included with the line 8 estimate. However, do not include expenditures for purchased heifers on line 8. Replacement expenses for these circumstances, like those for the example dairy, are addressed later in the analysis. Further, if the analyst wants to exclude heifer production from the milk production enterprise, do not record heifer growing expenses or the market value of home-grown heifers on line 8.

Net returns from the cow are obtained by subtracting annual feed and other expenses from annual gross revenues, $548 for the example (line 9).

If income from nondairy sources is used to service capital debt, enter the amount adjusted for expenses on line 10. This may include income from other farming activities or off-farm sources.

Recognize additional cash outflows in determining the funds available for servicing capital debt. These outflows include equity expenditures for capital items, family living, and income and social security taxes.

Enter annual per cow equity capital expenditures for the replacement or addition of capital assets on line 11. This is the producer's capital used to either purchase outright or make downpayments on purchased replacement heifers, facilities, equipment, buildings, land, and vehicles. The example producer estimated this amount to be $140 per cow. That estimate is based on a review of such expenditures in recent years, adjusted for inflation and anticipated changes in acquisitions. To exclude heifer raising activities from the milk production enterprise, include an expenditure based on the market value of replacements and the annual replacement rate on line 11. Also, if carryover debt from previous operating losses is present, include payment on that debt on line 11.

Enter an estimate of annual per cow expenditures for family living on line 12. H.O. Stein and family withdraw about $35,000 per year, or $175 per cow, to cover family living needs. Enter salaries paid to family members active in the business on line 8.

Record amounts paid annually for income taxes and self-employed social security taxes on line 13. Based on a projection of taxable income, H.O. Stein estimates taxes will amount to about $15,000 per year, or around $75 per cow for the 200-cow herd.

Many dairy farmers already carry capital debt and are primarily interested in how much additional debt the business will support. Thus, it is necessary to reduce the funds available for debt service by future annual principal and interest payments on already existing capital debt (line 14). These annual payments amount to $103 per cow for the example dairy.

Line 16 of the worksheet reflects the annual funds available to make principal and interest payments on additional capital debt. It is computed by subtracting total other annual cash outflows (line 15) from the sum of annual cow net returns (line 9) and annual income from nondairy sources (line 10). After making these calculations, H.O. Stein anticipates $55 per cow will be available to annually service added capital debt.

The amount of additional capital debt that can be serviced by line 16 funds depends on the interest rate and length of the repayment period for the added debt. An accompanying table indicates annual principal and interest payments on $1 of debt (i.e., loan amortization factors) for selected loan repayment years and interest rates. Record the payment corresponding to the interest rate and loan repayment period on anticipated additional capital debt on line 17. The interest rate appearing in the table is adjusted for taxes, since the worksheet reflects an after-tax analysis and interest paid on debt is a tax-deductible expense. To obtain the after-tax interest rate, multiply the before-tax rate by one minus the marginal tax rate. For example, H.O. Stein anticipates the additional debt for a waste handling system will carry a 10% interest rate and must be repaid over five years. Assuming a combined federal income and social security marginal tax rate of 40%, the after-tax interest rate is 6%, that is, 10% x (1-0.40). The annual principal and interest payment for each $1 of the 6% interest, 5-year loan is 0.237 (see Table 1). Enter it on line 17.

Compute the maximum additional capital debt on line 18. Divide the annual funds available for servicing added capital debt (line 16) by the loan amortization factor (line 17). The example producer can carry another $232 of capital debt per cow. The annual after-tax principal and interest payments on a $232 loan carrying a 10% interest rate (before tax) and fully amortized over five years would be $55, the amount the analysis indicates is available for servicing additional debt.

Add existing capital debt (line 19) to the maximum additional capital debt carrying capacity (line 18), to indicate the total capital debt carrying capacity (line 20). The example dairy producer has enough earnings to support a maximum of $707 capital debt per cow. Of that amount, $475 of debt already exists, leaving $232 of additional supportable debt. It should be emphasized that the $707 is the maximum supportable debt. Many producers will want less debt than is indicated on line 20 of the worksheet. Reasons for using less debt include an aversion to higher financial risk, that is, the obligation to make fixed principal and interest payments during a period of volatile earnings. Also, a producer may opt to use earnings to strengthen business liquidity and the ability to withstand risk through increased savings, maintaining a higher checking account balance, etc., rather than for debt service.

In today's heavily capitalized, narrow margin, and highly volatile milk production industry, effective debt management is critical to a successful business. Sound debt management includes establishing debt levels consistent with business earnings and producer feelings about financial risk. Due to substantial variation between businesses in earnings, cash flow, debt terms, and producer risk aversion, rules of thumb and the experience of others are often poor indicators of acceptable debt for a particular producer. The worksheet in this publication identifies the maximum appropriate capital debt carrying capacity for the individual producer. Use of the worksheet, coupled with conservative projections of earnings and cash flows, should reduce errors in decision making about the use of capital debt. Complete multiple worksheets reflecting pessimistic, probable, and optimistic assumptions for key, yet highly uncertain variables (e.g., milk price, feed costs, etc.). By knowing the range in acceptable capital debt carrying capacity, you will acquire a better feel for the financial risk and factor it into producer/lender decision making.