Make a list of working capital for farming.
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Understanding farm working capital
Most working capital shortfalls can be worked out if they are identified early, while there are still some manageable solutions available.
Kent Thiesse | Jan 25, 2018
We often hear phrases such as “protect your working capital,” or “watch your liquidity,” or “cash is king,” when referring to short-term financial analysis of a farm business. All of these terms generally refer to the working capital of a farm business. A significant decline in working capital in a farm operation can lead to a rapid deterioration of the overall financial outlook for the entire farm business and its owners.
The simple definition of working capital is total current assets minus total current liabilities. While that definition sounds quite simple, getting true and accurate working capital data can be much more complex in many situations. The current assets usually include available cash from bank accounts, accounts receivable, grain and livestock inventories, prepaid crop and livestock expenses, hedging account balances and any other short-term assets. Accounts receivable could include crop insurance or government farm program payments, deferred payments on grain or livestock that has already been sold and delivered, and money owed to a farm for custom or contract work.
The current liabilities include all accounts payable, unpaid taxes due, any crop input loans with Co-ops or seed companies, farm operating loan principal balance and accrued interest on all loans. The current liabilities also include the amount of loan principal payments due in the next 12 months (not the entire principal balance) on all term loans and real estate loans. In the case of grain that has been placed under CCC Loan with the Farm Service Agency (FSA), either the entire value of the grain should be listed as an asset and the loan amount as a liability, or just the estimated net value of the grain should be listed as an asset.
A financial ratio often used to express the level of working capital is the current ratio, which is simply the current assets divided by the current liabilities. A current ratio of 1.7 or higher in a farm operation is usually considered quite solid, while a current ratio below 1.2 is usually a warning sign of potential short-term financial challenges or cash flow difficulties in the farm operation. If the farm current ratio drops below 1.0, it likely means that there could be difficulty in paying all accounts payable at year-end, as well as repaying the entire principal balance on the farm operating loan for the previous year. In more serious situations, there could also be difficulty in paying all required loan payments on term loans and real estate loans. Ag lenders usually pay close attention to these trends.
A working capital to gross revenue ratio of 30 percent or higher for crop farms, and 20 percent or higher for livestock farms, would be considered as fairly strong. If the ratio drops below 10 percent, it is usually an indicator of some financial stress in the farm business, which may require some financial restructuring. If this situation occurs, it is best for farm operators to consult with their ag lender to find some workable solutions.
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Once a farm operator has identified the need for improvement in working capital in the operation, they should consult with their ag lender and farm business management advisors to develop a workable plan. Some possible ways to improve the working capital in a farm operation include:
Use any extra cash income generated by the farm business to pay accounts payable or to reduce the farm operating line of credit, rather than making extra principal payments on term loans.
Avoid spending excess cash from the farm operation to purchase capital assets or land, or to add unnecessary term loans with annual principal payments