Working capital is the king of financial metrics, especially during the bottom of a market cycle. A farm can have large swaths of land and other equity on its balance sheet, but if it doesn’t have cash or liquid assets to make monthly payments, the business will soon be in trouble.
“A wheelbarrow full of dirt doesn’t pay the bills,” notes Dr. David Kohl, agricultural economist and professor emeritus at Virginia Tech. He joins us for episode 16 in the Mind Your Farm Business series to discuss the importance of working capital — what it is, how to track it and how to improve your working capital position.
“As we’re playing in this very volatile global economic environment, where costs and prices are all over the board, it’s very imperative that agricultural producers and businesses have a financial shock absorber in working capital,” he says.
Simply defined, working capital is current assets, such as cash, inventory and receivables, minus current liabilities, such as accounts payable, operating line payments and loan payments due in the next year. A healthy amount of working capital makes a business resilient during tough years and agile when opportunities arise, notes Kohl.
“If you have working capital, if you have cash, sometimes you can be in the marketplace to buy other people’s assets at 50 or 60 cents on the dollar,” he explains, referring to the used machinery market in the U.S. right now as an example where some producers are seeing this opportunity.
Most lenders look at the current ratio — current assets versus current liabilities — to assess a farm’s ability to cover its liabilities without disrupting operations, however Kohl prefers to compare working capital to annual farm expenses, including depreciation.
“We like to see it above 33 percent,” he says. “We’re finding the top 25 percent of managers will generally keep that ratio above 33 percent.”
The rate at which that working capital, which Kohl also aptly describes as “rocket fuel,” is used up is called the burn rate. Working capital divided by annual losses should equal at least one (enough working capital to cover a year’s losses.) Ideally, it should be above three years, says Kohl.
As he explains, there are three main ways to increase working capital:
1.) Build working capital during the top part of a market cycle. Kohl suggests following a 60:30:10 profit plan — 60 percent of profits are invested in growing the business and making it more efficient, 10 percent are paid out as dividends and the other 30 percent is diverted into building working capital.
“You won’t get much return at the top part of the cycle, but your return is when you don’t have to sell assets at 50 cents on the dollar. And your return is you might be able to buy someone else’s assets at 50 cents on the dollar,” he explains.
2.) Sell land or other assets. The problem with this is others are likely also selling, leading to discounted values.
3.) Refinance short-term debt over a longer term. “You can stretch out your operating losses onto term debt, but if a producer does that, they have to come back with a written plan how they’re going to improve their situation so two to three years later they’re not back there knocking on the lenders’ door,” notes Kohl.
Not all forms of current assets (or current liabilities) are equal, as he recommends breaking down both sides of the balance sheet according to timeframe. 10 percent of current assets, or at least one year of debt payment, should be instantly accessible as cash on hand, he recommends. He also cautions producers about considering pre-paid expenses as current assets, as their revenue might not be realized for 12-18 months or whenever the specific expense is incurred.
For farms looking to grow aggressively, such as young producers buying their first land, he also suggests stashing at least a year of debt payment in the bank as soon as possible.
“Still grow, because you have to grow, but do it in a disciplined way over a five to seven year period, and then if some adversity comes, you’ll have it to withdraw from,” says Kohl.
While the other financial measurements such as debt-to-asset ratio are still important, there’s extra emphasis on financial liquidity and working capital when going into the trough of an economic cycle.
“In the past we’ve depended so much on equity on the balance sheet, but in the current markets and the way things are going, you have to be resilient and agile,” says Kohl.
Listen to previous Mind Your Farm Business episodes
Disclaimer: Royal Bank of Canada and its subsidiaries are not responsible for the information provided in this podcast, and this information does not necessarily reflect the views of Royal Bank of Canada or any of its subsidiaries. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by Royal Bank of Canada or any of its subsidiaries.
Subscribe: Apple Podcasts | Google Podcasts | Spotify | RSS | All Podcasts
Please register to read and comment.