Do you like the colour of my brand new debt reduction?

With the prospect of better returns in the 10/11 season,  Neil Lane is encouraging farmers to consider putting the spare cash into one of their more profitable investments - debt reduction.

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Do you know the problem with debt reduction?

• You can't park it out the front of the pub or football club for all your mates to admire
• It doesn't have the show room smell of new vinyl
• It doesn't come with the latest features that early models of debt didn't have
• It doesn't provide you with some sort of false economics tax deduction

In short you can't show it off, and it is not a tangible indicator to the outside world that you're business is generating profit, or you are able to borrow more money (not necessarily the same thing).

In the past month or so we've started to see the first signs that some spare cash is starting to creep back into the more profitable dairying businesses. I am very mindful of how tough it has been since the milk price step down in February 2009. It has been an even longer and tougher run if your irrigation supply and/or normal rainfall had dried up. For many farm businesses recouping past losses will be the priority for some time yet. If however there is spare cash, what should we do with it?

Will there be spare cash? If we take a quick look at the current operating environment;

• Xcheque believes that the Australian and New Zealand milk price forecasts for 2010/11 are realistically forecast at $AU 5.20-5.40/ kg MS and $NZ $6.90 / kg MS respectively.
• While rainfall can stop tomorrow, in Australia we have the prospects of a longer growing season and plentiful irrigation water over the larger proportion of the dairying regions.
• Despite the recent dry conditions New Zealand is on track for milk production at or above last year
• The mixed bag of input prices is sitting at or below long term trend lines.

I genuinely believe that the only thing keeping a lid on industry sentiment is the preceding tough period (including the recent wet, cold and muddy start to spring). If you look at how the planets have aligned at this point in time, there is not much more we could really ask for (except that they stay aligned for the next couple of years and perhaps for cows prices to return to normal levels).

So my advice to clients, and anyone else who wants to listen, has been to pay off debt, pay off debt, pay off debt ..... and/or deposit any profit in a Farm Management Deposit, FMD, FMD....⁽¹⁾

Debt servicing is a necessary evil for most of us. What makes it worse is that it is a fixed cost to the business. The expense is there come rain, hail or shine.

Debt reduction lowers these fixed costs of interest payments and scheduled principal repayments. It makes the business resilient, providing a more comfortable ride in tough times and greater profits in the good times!

It is also my experience that banks look favourably on clients who have a proven ability to repay debt over time. That will be important credit when the time comes to extending loans and overdrafts or making that important future asset purchase.

I fully admit that I have become a self confessed, old before my time, 'fuddy duddy'; sounding like someone who lived through the Great Depression; a 'you be wary of debt' Octogenarian or Nonagenarian. In the opinion of this author however, the world, including the dairy industry, remains a volatile place. I am yet to meet anyone who has regretted paying off debt or putting money aside in the likes of an FMD.

Now I acknowledge that farm equipment needs replacing and catch ups in repairs and maintenance or fertilizer need to be made. Profitable years are the logical time to do this. I am also a firm believer that farmers should be able to allocate some of the rewards to themselves and their families.  Like the rest of the community, they are entitled to better cars, houses, holidays etc. - but not all in the one year please!!

I am reminded of the 'ideal gas law' that states: 'gas will expand to the volume available'. This leads us to 'Parkinson's Second Law' which states: 'expenditure expands to meet the income available'. ⁽²⁾ It is all too often in the more profitable years that increases in expenditure creep into our farming businesses. The longer the 'spare cash' lasts for, the more expenditure creeps in. It then becomes harder, both physically and psychologically, to unwind costs when the inevitable drop in farm profitability occurs.

So by all means if the spare cash allows, consider a good holiday, or renovate the kitchen and catch up on the essential expenditure around the farm. But before you make a final decision ask yourself the following questions:

• When the profitability of the dairy industry is next challenged by low milk price, dry conditions or high input prices, do you want more or less debt for the same sized business?
• When the profitability of the dairy industry is next challenged would you prefer to have some cash reserves tucked away in a FMD or some other tax effective haven?
• When the profitability of the dairy industry is next challenged do you want higher costs of production imbedded in your business?

⁽¹⁾    For non-Australian readers, FMD's are a tax management benefit available to Australian farmers. Profit can be held in a bank deposit account and tax is only payable when the money is drawn out of the account. This allows some degree of tax averaging between high and low profit years.

⁽²⁾    Parkinsons first law states  - 'Work expands so as to fill the time available for its completion.' (but that's another story we'll leave to a later)