Focus on Ag: Pay attention to working capital in farm finances
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 coops 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 a 9-month 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.
The financial ratio that is 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 typically a warning sign of potential 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.
Another ratio that many farm financial advisors and ag lenders follow very closely is the level of “working capital to gross revenue” in a farm operation, which more accurately reflects the liquidity needs based on the size of a farm operation. That ratio divides the calculated working capital for the farm operation by the annual gross revenue of the farm business. For example, a farm operation with a calculated working capital of $200,000, and an annual gross revenue of $400,000, would have a ratio of 50 percent, which would be quite strong. However, if a farm operation had a gross revenue $2 million with $200,000 working capital, the ratio would be only 10 percent, which could be a financial concern if not addressed.
A “working capital to gross revenue ratio” of 30 percent or higher for crop farms, and 20 percent or higher for livestock farms, is usually considered to be 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 explore some workable solutions.
Based on the Farm Business Management (FBM) records for over 1,450 southern and west central Minnesota farms, the average “working capital to gross revenue” ratio in 2018 was approximately 23 percent, which is a decline of nearly 6 percent in the 5-year period from 2014 to 2018. In 2018, crop farms had an average ratio just over 30 percent, with most livestock farms at much lower levels and dairy farms averaging a ratio of only7.5 percent. The data also showed that farm operations that were in the bottom 20 percent of net income in 2018 had an average ratio of near 4 percent, while farm operations in the top 20 percent of net farm income had an average ratio of over 41 percent. There was very little difference in the average ratio among different sizes of farms that ranged, from 500 acres to over 2,000 acres.
As we enter 2020, the level of working capital will likely be a concern for an increasing number of farm operations. This is due large variations in 2019 crop yields and year-end grain inventories, continued lower values for grain inventories, as well as increasing levels of accounts payable and farm operating loans at the end of 2019. Farm operators in portions of the Upper Midwest that incurred reduced crop yields last year, due to excessive rainfall are especially feeling some added financial stress from the decline in working capital, as compared to a year earlier.
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.
• Consider refinancing term loans and real estate loans to longer term financing to reduce annual principal payment requirements. Long term interest rates are currently still quite favorable.
• If the farm operating loan is close the maximum principal level, or if the farm operation had carryover farm operating debt from the previous year, it may also be advisable to refinance some of the farm operating debt with longer term financing.
• Consider selling any unused or extra farm or personal assets, possibly including a land parcel, to generate some extra cash to be applied as payments on the farm operating loan. Remember to account for the tax liability when considering the sale of land or other assets.
Most working capital shortfalls can be worked out if they are identified early, while there are still some manageable solutions available. Most ag lenders and farm business management advisors are well prepared to assist farm families with working capital strategies for their farm operation.
Kent Thiesse Farm is the Management Analyst and Vice President of the MinnStar Bank
Article courtesy of Farm Forum.net