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ELK PROFITS Part II
Leveraging Elk / A tool or a Curse?
by Rich Forrest, Mountain Velvet, Ltd.
Secretary/Treasurer, Colorado Elk & Game Breeders Association COPYRIGHT 2000
ortgages, you either love ‘em or hate ’em. That’s what leverage is, a mortgage. The use of borrowed money to increase your buying power. “OPM”, Other Peoples Money. OPM allows us to buy our homes or ranches, to get that car or piece of equipment we want, or put our kids through college. Unless you’re pretty well off, we all use OPM, most of us just plain need it, sometimes on a regular basis. A ranch always needs more cash late in the season, and who keeps stacks of cash handy for those large purchases, ... anyone out there?
Well, that‘s why banks were created, to take in OPM and have it handy for us to borrow when we need it or want it. OPM can be used for necessities like housing and transportation ... to finance fun or education ... or it can be used to make more money. The old saying is “It takes money to make money." Our objective with leverage is to make more money using OPM than the bank charges in interest. How can one do that?
We know that in our current market, elk make money. Big money, as some say. The previous article “Elk Profits, A 45-Month Case History” showed that a rancher can achieve a rate of return in the mid-20% range by buying right, having good management practices and keeping his learning curve pointed upward. Success is possible even with some bad luck.
It stands to reason that the more elk one owns, the more money one can make. But, here we have a choice. We can either wait for mother nature’s annual gift (our calf crop) or we can go out and buy more elk. Unfortunately, buying more elk takes more money. More money than we usually have available. But, Hey! Maybe that’s what OPM can be used for. We can leverage our elk into more elk! Where one is, two can be!
We are all familiar with leverage. Like using a hammer to pull a nail out, or a pry bar to get those rocks out. Leverage uses a smaller amount of work (or money) to accomplish a greater amount of work (or gain). In our case, leverage, or the use of borrowed funds is like a financial teeter-totter. A little money, in hand, can do the work of a larger sum of money.
The use of monetary leverage in a stable or rising market can boost one’s rate of return significantly, sometimes by several percentage points. Likely even well above the 24% rate of return we found in the first case study article.
This significant improvement in financial return, can enable one to get that land paid off more quickly, buy more equipment or even buy more elk, maybe even leveraging them. All this can be done with only a modest increase in risk, but only so long as the market remains relatively stable or is climbing.
Elk are commodity, just like corn, or gold, or cattle futures, sometimes the market is up, sometimes down. Seemingly, it takes an expert or a crystal ball to know where the market will go. But, if you’re not paying attention, the market will get the best of you. When using leverage, watch that market and be ready to correct your activities quickly to suit the conditions.
In recent years with elk, we have all been blessed with a rapidly rising market through the 1980’s, forming a plateau in 1990-’91 and failing back a bit from 1992 to 1994. The last two years, ‘95 and ‘96 have again been a “bull” (upward) market, particularly for select genetic lines. The 80’s and even the early 90’s with the plateau and slight settling played well for the use of leverage. The recent two-year upward trend is equally encouraging. It has been very profitable for those with well-established elk herds.
Greatly enhanced velvet revenues can be generated by leveraged bulls.
But how can you make more money by borrowing money? How does this work? In the previous article, “Elk Profits, A 45-Month Case History," a rancher could have invested $24,800 to buy four guaranteed pregnant elk cows. Four years later, despite several problems, that rancher could have taken out some $29,319 in cash and still had some $18,600 worth of animals after 45 months. A fairly good return of 24.3% compounded annually! That $23,000 of gain could buy a bit more land or part of that new tractor or even gotten the kids through a few years of college.
Well, what can be done to improve that return? Better management? Sure! better genes? Good! Those will help, but leverage can do just as well, and you can do it with what you currently have available.
Let’s say that instead of digging deep and plunking down the full $24,800 for cows, Mr. Rancher, puts $12,400 down on those cows. He socks away any extra cash for a rainy day and heads down to his local bank to borrow the remaining $12,400. If your banker knows elk, he will probably specify a 50% Loan to Asset ratio (LTA). These days, banks will generally loan up to a maximum of a 50% loan to value ratio on most livestock or elk.
A fully leveraged cow elk -- Stretching those elk dollars
The Loan to Asset ratio is simply the amount of the loan divided by the total value of the loan collateral, in this case the cows. ($12,400 borrowed divided by $24,800 collateral value = 0.5 or 50%). So, Mr. Rancher borrows 50% of the necessary cow purchase amount ($12,400) at an interest rate of say 10% annually, amortized over 8 years with a balloon payment at 4 years. Each year the interest and 1/8 of the principal ($1550) must be paid back to the bank. A balloon payment of $7,750 is due at the end of 48 months. The purchased elk are the collateral A good credit rating will certainly help in this transaction, but as a fall back, land can almost always be used as collateral, if it’s available.
With $12,400 of his own and $12,400 of OPM, Joe Rancher buys those same real four guaranteed bred cows that we learned about in “Elk Profits.". All the direct elk costs remain the same, except now we have an annual interest payment of 10% due in the 4th quarter of each year. Year 0-1 = $1240, Year 1-2 = $1085, Year 2-3 = $930 and year 3-4 = $775. Remember that additionally 1/8 of the original loan principal amount ($1,550) must be paid down each year.
On Table 1, all the financial information for the entire 45 months has been tabulated, this time including interest and loan principal pay down. The rancher pays only the costs directly related to the animal such as testing and vet costs, including feed costs of approximately $1.00 per day per adult animal, lesser for calves and yearlings. There are no other charges for the cost of labor, improvements or other non-direct costs of the animals. All income and expenses are tabulated quarterly. Chart 1 portrays this information graphically by quarters over the life of the venture.
As per our original findings in the initial Elk Profits article, the elk investment is quite profitable. All cows were purchased for an initial cost of $6,200 each, guaranteed bred. Despite several adverse events, including loss of one cow by lightning and several offspring deaths, the four cows originally purchased produced a very respectable 24% annual profit. These were animals being cared for in an ordinary fashion within an 800-acre enclosure on the Northeastern Colorado prairie requiring supplemental feeding all year.
Discussion of Performance Cashflow-wise, from the leveraged rancher’s perspective, the OPM elk purchase is cash demanding early on, but is lucrative in the long run. Emphasizing herd growth during year 1, only one bull calf was sold. Extra cash of $1,438 was required by the venture, predominately to cover the required loan interest and the year-end note paydown.
During year 2 an additional $3,135 must be added to the venture, again to cover the loan interest and note paydown. At the end of year 2 our total cash exposure is at its maximum of $16,974, some $4,574 above our original $12,400 cow commitment. Keeping some cash money handy for that rainy day was a good idea!
Year 3 saw a major change in emphasis toward a different genetic line of animals. The remaining original cows were sold with the proceeds removed from the project. Significantly, some $16,853, fully 136% of the rancher’s original investment was converted to cash in this year. Plenty to buy more elk!
Lastly in year 4, an additional $9,025, or another 73% of the original investment was withdrawn from use via animal sales. Of those cashed out funds, $7,944 was used to payoff the remaining loan balance and interest. Over the full 45-month period some $17,934 of new cash (or 144% of the rancher’s own original investment) was removed from the venture and could be used for other elk investments and general operating funds.
The remaining animals were valued at $18,600 or about 150% of the rancher’s original cash investment. Fifty percent more than what we started with! Total return equaled $36,583 against the original $12,400 investment plus an added $4,574 of additional sunk cost through year 2. A 215% cash on cash return in 45 months. More than a double in less than 4 years! Chart 2 “Leveraged Ranch - Year End Asset Value” portrays the financial position of the venture at the end of each fiscal year.
Double your bull buying power
On the rancher’s full $16,974 cash investment (the original investment plus the necessary added-in cash), the internal rate of return “IRR” (the interest rate you are making on your investment) ranges from 22.3% to 43.0% per animal with an average of 30.8% compounded annually. This is a pre-tax return rate. No provision has been made for the payment of taxes.
Basically, when tabulated over the full 45 months of the study, this compounded IRR rate of almost 31%, is earned each and every year, even with the initial negative cashflows of year’s 1 and 2, and paying down the loan. Proof positive that leveraged animals can really make more money.
The leveraged IRR at 30.8%, has improved a tidy 27% over our original non-leveraged 24.8% rancher’s return rate. Over a 1/4 increase in our profitability without hardly lifting a finger, ‘cept maybe to chew a nail or two.
Total cashflow and residual value from each animal varied from a low of $5,545 for cow #F2 to a high of $14,120 for cow # F1, for a range of $8,575. Each individual animal generated a positive cashflow measuring from a low of $2,013 for cow #F3 to $11,020 from cow #F1, for a total positive cashflow of $18,940. This $19 thousand was new cash generated by the animals over the 45-month period. That new cash could be used for all kinds of good things.....like buy more elk! Remember though, that in any one year the cashflow could have been negative for a significant period of time. This means that you must be ready to dig into your pocket for that rainy day cash, when necessary.
Potential Pitfalls: Now, not every scenario with leverage is always so rosy. Leverage works both ways. You can magnify your losses with poor management, or get really clobbered in a failing market. What happens in a down market as animal prices slide? Unfortunately, from just a modest risk in a stable market, risk to your investment now increases dramatically. Leverage correction in a changing market is always very important. We all know what happens when an adult moves to the end of a teeter board with a child. The child is stranded, or at worst, is catapulted off! This brings up another old saying “if you can’t stand the heat ... stay out of the kitchen.”
Leverage is not for the faint of heart, nor for a sour market. A sour market, in my mind, is one headed down seriously, 20% of more in less than 6 months. Minor downtrends are not a problem so long as you are prepared to maintain that bank-required Loan to Asset (LTA) ratio. Sometimes, borrowing at less than a 50% LTA has its advantages.
Let’s look at a sour market scenario. On our $24,800 cow purchase, the initial 50% Loan to Asset ratio is suitable for that $12,400 loan. But let’s say that right in our first few months, before we can get any new calves, elk prices dive by 20%. Our 4 cows are now worth only $19,800. Hmmmm, the bank is not so happy now. A $12,400 loan on $19,800 of collateral, a 62.5% LTA, too high for the bank’s comfort. Livestock are rarely allowed to exceed a 50% LTA.
If they are not comfortable, the bank will demand that the loan be restored to the prerequisite 50% LTA. This means increasing the amount of collateral or sometimes literally paying the loan principal down to about $9,920. Do you have that extra $2,480 handy? That rainy day money would be useful!
What happens in a seriously sour market, say a 50% decline in animal prices? Kiss your cows good-bye. Your four cows for which you paid $24,800, are now valued at just $12,400, .... conveniently just the value the bank needs for paying off the loan. This is a problem. An elk liquidation sale may be brewing. None of your original investment is left and you’ll still owe the interest! A very serious problem.
To escape the possibility of a banker’s wrath, always, always watch that market and be ready to cover your leveraged position with animal sales if the market weakens seriously. It is always better to be safe than sorry.
Conclusions. Once again, the animals used in this study were average animals of uninteresting genetics. They probably did not appreciate as much in value as would have well cared for, “select” animals. Your own individual results may vary widely.
This study also assumes that the ranch and facilities were already established and operational. For a new ranch, an amortization factor may need to be added to cover the cost of these new developments. Lastly of course, the rancher must also make a significant contribution of effective time to the equation. Without that, none of the profits will ever appear.
Conclusively, the use of leveraged assets in a stable or upward trending market will provide a significantly increased profit at a reasonably low rate of risk. These bonus rewards are easily available to the ever watchful and resourceful elk rancher. In a downtrending market, guard your cash and avoid that leveraged position.