The recent financial windfall in the grain sector and, to some extent, the livestock side of agriculture has more producers considering expansion. A group of producers, who were considering both land purchases and expansion of livestock facilities participated in a recent webcast. They were concerned about a subsequent downturn just after expansion, which historically has driven some out of business. They asked, “Do you have any guidance and wisdom when examining an expansion?”
First, does the expansion mesh with the goals of the owners, managers, and any influencers such as spouses or investors? In order to be successful, it is important for everyone to be on the same page.
In an inflating economic environment, cost overruns are being observed for construction projects ranging from homes to livestock facilities. Build in at least 25 percent extra for cost overruns and extra time to completion for the project. Supply chain issues and the lack of productive labor in the construction business is a fact of life in today's world. Recently, a banker noted that a $3 million dairy expansion had a $600,000 cost overrun and the project was only 75 percent completed.
Next, it is critical to pay attention to working capital both pre and post expansion. One suggestion is to have at least 15 to 20 percent of operating expenses as working capital. Drilling deeper, working capital to total debt service, including both principal and interest payments, should exceed 3:1 and in best cases will be greater than 5:1. Working capital provides a financial buffer or cushion for adversity or in cases of a black swan disruption like the COVID-19 pandemic.
Financial leverage kills when economic adversity occurs. One measure used as a guide for financial leverage is term debt divided by EBITDA*. Solid guidance is when this ratio is under 3:1. When this ratio exceeds 6:1, tap the brakes! Another test for this ratio is to conduct best, average, and worst-case scenarios concerning production, price, and costs. Often the worst-case scenario will place the business’ financial metrics in a situation where the term debt to EBITDA ratio exceeds 6:1. If this is the case, one needs to consider what is the probability of the worst-case scenario occurring?
While the aforementioned advice will not guarantee success, it will provide some insight and guidance in keeping the business out of the financial ditch.
*EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and
Source: Dr. David Kohl, which is solely responsible for the information provided and is wholly owned by the source. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset.