The idea that positive cash flow somehow implies profitability is plainly wrong.
Cash flow gets a lot of prattle and positive press in agriculture. Most often it is considered a measure of liquidity. Perhaps more important it is a watermark for bankers because it shows, generally, that you will have the money to pay them what you owe when the payments are due.
However, a positive cash flow for your banker doesn't mean there will be anything left over for you.
"Bankers ultimately just want their money repaid. That's the world you live in," says Stan Bevers, Texas AgriLife economist at Vernon.
Further, using cash flow as a financial diagnostic tool is financially dangerous. Beef Producer columnist Walt Davis recently said, "Just because something will cash flow doesn't mean it's a good use of your money."
Ultimately, if you're just making cash flow you are just "surviving," Bevers says.
If you are truly accounting all your costs and have plenty of cash flow, plenty of working capital, and if your net worth is increasing, then you could argue that your positive cash flow is a sign of profitability. That, Bevers says, is "thriving."
Truth is, the way you do your accounting determines whether or not positive cash flow can serve as one sign of financial well-doing, Bevers suggests.
Here's the rub. Two of the three biggest ranch expenses are depreciation and labor. Labor includes family living expenses, Bevers says.
Depreciation exists whether you pay cash for things or not and whether or not you deduct it on your tax forms. It is a real cost because equipment wears out, as do cows, and must be replaced.
On many mid-sized ranches most of the labor is that of the operator, therefore it is never accounted nor is it deductible as an expense from taxes. This is particularly true for operations the size of 200-300 cows for instance, Bevers says. All the same, money comes out of the operation for the operator's costs of living.
Even if one or both of these big expenses aren't being accounted, a beef operation could show a positive cash flow to the banker and yet be technically losing money, specifically losing net worth.
So, to get on with the cash flow discussion Bevers says it might be good to rename the four profit "quartiles" from the Southwest SPA database which he manages. Standardized Performance Analysis (SPA) requires the same methods of accounting for all ranches taking part and therefore gives reasonably comparable financial information. Thereby it allows reasonably accurate comparisons of how management affects profit.
If you look at the charts with this story you'll see the most profitable quartile is #1 and the least profitable quartile is in fourth place.
Regardless of which profit category these ranches fall into, the three largest expenses are labor, depreciation and purchased feed, all averaging about 16% and together making up almost half of all expenses. SPA forces an accounting of these three, even if they are not in the management's records.
Imagine, then, how the "cash flow" of an operation could look different if labor and/or depreciation were omitted, especially from the higher-expense/lower-profit operations.
To reiterate, the cost for labor is coming out of the operation even if the owner isn't paying himself a salary, for example. When it is time to pay bills there may not be enough money to "cash flow" some expense.
Depreciation is happening whether management admits it or not. When it's time to build fence or replace a worn-out pickup but nothing was set aside in profits and excess working capital, the replacement cost could disrupt "cash flow" and put the operation at a greater financial risk.
Thriving or less?
Considering all that, here's what Bevers says he recently suggested to a group of beef producers they more or less re-label the four quartiles this way:
First quartile = "Thriving."
Second quartile = "Surviving."
Third quartile = "Barely cash flowing."
Fourth quartile = "Losing wealth."
The group which is thriving has the lowest costs, the highest profit and the highest return on assets at about 8%. None of the others are close.
As always, low-cost operation is proven paramount.
"Micro-economic theory says the price received for any product is going to migrate down toward the average cost of production," Bevers says. "If micro-economic theory is correct, and it generally is in agriculture, then the only way to compete is to find ways to lower your fixed and variable costs below the average."
Although we've concentrated much of this discussion around data for cow-calf operations, this applies to all beef operations.
In fact, Bevers says these principles of low-cost production as the primary path to profit apply even more acutely to margin businesses such as stocker and backgrounding operations and feedlots. That's because there is much more purchasing of inputs in order to produce the outputs and much more turnover of money. This actually provides a much greater portion of the operating budget as variable inputs. Arguably, this could mean more opportunity for cost savings or losses.
Download Bevers' Powerpoint at the link on page one.