With all the uncertainty surrounding markets in the wake of COVID-19, farmers are reaching for every option to stay afloat. You might find yourself considering restructuring your balance sheet, but is it the right time?
“Because of the way the dairy environment has been for the last several years, this has become a perennial question,” says Sam Miller of BMO Harris Bank. “The first thing that people have been focusing on is having enough working capital. How can you make sure that you’ve got enough?”
One way is to restructure debt, Miller explains. To do this, you need borrowing capacity and long-term assets such as land or livestock.
“And you need to demonstrate what you’re doing to manage price risk in particular,” he says. That could be enrollment in the Dairy Margin Coverage program, the Dairy Revenue Protection program or other tools like hedging.
When you’re evaluating a debt restructure, the first step is to
consider is how much debt you have says Jay Joy of GPS Dairy Consulting LLC.
“Think about the common
measurements of how your equity compares to how much debt you have on a per cow or per hundredweight basis, so you have some idea how much debt are you carrying and how much of that has to be serviced,” he advises.
There are benefits to restructuring, of course there are also some downsides. Weigh the pros and cons before making your final decision.
Access to working capital. “I think that the first thing you’re thinking about is, is that working capital,” Miller says. “Do we need it?” If so, a restructure might make sense.
Manage cost of production. “You can manage cost of production some by doing re-amortization if you’ve got some debts paying off pretty quickly,” he says. However, moving debt down the balance sheet can also increase cost of production because you’ll be paying principal and interest on a long-term debt where you might have only been paying interest on a short-term debt.
Capture low interest rates. At press time interest rates were near historical lows. Restructuring some debt can allow a producer to take advantage of those rates, but it’s important to be aware of what kind of debt you have and where it falls on the balance sheet, Joy says. “You need to know the types of debt you have and how it got on the balance sheet to begin with,” he says.
Prepayment or make whole penalties. Over the past several years dairy farmers have taken advantage of low interest rates. “On some of those deals, even though rates might be lower today, you likely have a prepayment or a make whole penalty inside that agreement,” Miller explains. “If you break it, you have to make that payment in order to lower your rate.” Producers should weigh out the penalty too.
Higher cost of production. Restructuring tends to raise your cost of production because now you’ve got a principal and interest payment to fund versus if you had just left it floating on a variable rate on the line of credit, Miller explains. “You are not servicing that principle, you’re just servicing the interest component of it until you’ve got profits to pay it down.”
Reduce borrowing capacity. Moving short-term debt down the balance sheet means having to tie up longer-term assets. “You reduce your borrowing capacity in future periods of time because you’re tapping into equity of longer-term assets in order to refinance out of your short-term debt,” Miller says.
At the end of the day, restructuring the balance sheet does not equate to profitability.
“We can be highly unprofitable, but we can still have cash flowing,” Joy explains. “So what we need to know is if we are generating enough cash to pay all of our bills, meet our debt service requirements and then provide a cushion for contingencies to build our balance sheet.”