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Building wealth vs. building income

James Coffelt for Progressive Cattleman Published on 23 February 2018
Bull grazing

As a group, farmers and ranchers are the hardest-working, highest-quality, most honest people around. They’re also among the poorest financial thinkers.

A favorite book of mine is Knowledge Rich Ranching, by Allan Nation. A main principle from the book is: Building wealth is different from income. Income is used to live. It is the cash flow. Without it, we are out of business. Cash flow, or lack thereof, sinks ships. It is required.

All income above what is required to live can be rolled into appreciating assets. There is no better business than this business for accumulating appreciating assets pre-tax.

Ranching is remarkable from a pure business standpoint, with its wealth-building abilities.

There are three financial tools critical to building wealth: an income statement, balance sheet and a personal financial statement.

The income and balance sheet are used for the tax man. They include depreciation and a variety of items that change the true picture of wealth building.

The personal financial statement is the correct picture of wealth building. Every bank will provide a blank form and update it twice a year to measure its progress.

Back to building income: If a spouse complains there is no money in the checking account, that is a cash-flow issue. It is possible to have a great year of wealth building, with poor cash flow, and a great cash-flow year with diminished wealth.

Building wealth is measured on the personal financial statement. It is possible to have a year or more with negative wealth building; it is not possible to have long periods of negative cash flow, as the cash and borrowing ability evaporate, and you’re out of business.

As I think back over 30-plus years of business, each 10-year period might have two years of losses, two years of “out of the park” earnings and six years of good enough. Had we not been in the game when it mattered, the two great years would have been missed. Some common examples:

Land

Land is an asset that appreciates, and that additional wealth is not taxed until the land is sold or never taxed, depending on your strategy. Through this, land wealth increases. The cattle herd is larger and better, so livestock wealth increases. That appreciation is real wealth. That wealth is not in the checking account, but it could be via refinancing or selling land and livestock.

Selling will prompt taxes; financing does not, and with financing, you still own the land.

Many are averse to debt. But it is a financial tool that can be used well or not used well. At our operation, we are comfortable with up to 40 percent leverage, with the idea if things went south, we could take the hit. Money, at the moment, is almost free or close to it at 3.5 percent, which is, in turn, deductible from income.

Effectively, it is 3.5 percent less than your upper tax bracket. Meanwhile, pasture land has appreciated 7 percent in our area, using a three-year rolling average. Land wealth grew by around 5 percent after interest.

Land can produce income from cattle, hunting, gas and oil, timber, pipeline, solar and wind energy, maybe even mining, and so on.

If you do not already own the land when gas and oil, mining or other opportunities appear, it is too late. This is the benefit to owning land when possible. You must be in the game before it starts.

The recent tax law increases the estate deduction to $22.5 million. Most will be able to move assets to the next generation tax-free. Taxes are an enemy of building wealth.

And, as a side issue, what is the most liquid asset? Cash is first, but close in second is livestock. Your cattle may not be sold at the top of the market, but livestock is highly liquid. Like stocks, timing the market is difficult.

Livestock

Cattle and other livestock produce income. However, there are a lot of moving parts. In our case, the model is the ability to sell into a premium market, whether it be bulls, seedstock, all-natural steers and grass-finished beef. All ours are registered black Angus because they sell for more as registered and consume the same forage as commercial. Is it perception or real? I simply know registered animals sell for more.

The animal class also matters. Consider the value cycle of a cow. In our case, a heifer calf might have a $1,100 value. But if you keep that heifer another year, at a cow cost of $296, its value jumps to $1,900 if bred to a good bull. The cow’s value will remain there or increase up to around 5 years old, and it will then depreciate in value.

One goal is to turn the herd over while cattle are younger, before the value drops. This is assuming you use good bulls because the genetics are better with each generation.

Consider using older cattle for grass-finished beef. The flavor is better, and they marble/finish easier. While some middle meats will be lost over 30 months, the carcass size more than offsets what was lost. This helps with herd turnover.

While we sell bulls, my opinion is that this is a mostly female business: Cows calve and consume more forage than a young cow or heifer. Steers gain weight. Young cows gain weight and calve. While the young cows will produce smaller calves, they permit more animals on the same forage or acreage.

Young cows will produce smaller calves

This produces more total calves, which more than offset the smaller calves by some 20 percent in a production-per-acre model.

Buying appreciating assets, cattle and land, in that order, with the income to live nicely, is the model. If costs are high, there is no cash to buy, borrow or accumulate wealth.

Become fully stocked first, as the largest driver of profit is stocking rate. It is a production-per-acre model, not production per head. With high turnover and good bulls, genetic improvement is advanced quickly.

Stocking rate is the key driver of profit

Costs

I had mentioned cow costs of $296. This includes year-round grazing, no vaccinations, no worming and no labor or injuries, to man or beast, while performing those activities.

Genetics, and cow size and type, matter. Pharo, Pinebank and Wye genetics work well here in Ohio.

Traits such as moderate size, moderate milk and moderate growth enable cattle to finish on grass. Our model caters to animals that thrive in a low-input management model and are able to sell into premium markets and the commodity market.

The less equipment used, the better. We run an 8,000-acre ranch with one 100-horsepower John Deere tractor, two diesel trucks, a stock trailer and some ATVs. Why John Deere and diesel trucks? Simply, they hold their value.

Some costs can be converted to profit centers. For example, until last year we had assigned a $23 breeding cost to each cow for the cost and value of breeding bulls. A friend and large rancher uses A.I. extensively, and his breeding costs were also $23.

Last year, we began leasing our bulls to others. We use three breeding seasons – spring, summer and fall. We calve in May and June and, consequently, can lease bulls in spring and fall, producing income. Many herds are small. So the idea of buying a good bull and exchanging bulls with a like-minded cattleman using a similar-quality bull, can reduce costs in half. The savings are even greater by using a third friend.

Because the bull is profitable, better bulls can be purchased, which in turn makes them easier to lease or exchange.

In short, invest in appreciating assets: livestock first, land second. Avoid spending on depreciating assets and labor.

Taxes

If a ranch made some money, buy appreciating livestock, which can be expensed. Do not buy equipment unless absolutely necessary. Many accountants depreciate livestock as opposed to expensing. This is a mistake. Livestock is income when sold, expensed when bought.

If you sell land, place the money in a 1031 exchange, tax-free. Assuming it takes 90 days to close, you will have six additional months to buy other land with those pre-tax funds, for a total of nine months to purchase. Buying with pre-tax money increases the capacity to buy with the amount that would otherwise have been paid in taxes. Taxes are the enemy.

Peter Drucker, the famed business writer, said it best, “Every idea, every activity, every employee and every business model should be on trial for its life, every single day.”  end mark

PHOTO 1: The better the bull you buy, the more profit you can make from lease or exchange.

PHOTO 2: Young cows will produce smaller calves, which places more animals on the same forage or acreage.

PHOTO 3: Stocking rate is the key driver of profit, especially if you use a production-per-acre model for your ranch. Photos courtesy of Ohio Land and Cattle.

James Coffelt is with Ohio Land and Cattle in Cadiz, Ohio. Email James Coffelt.

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