Cash is King, as the saying goes, and it is certainly true in farming.
Working capital is the “cash” a farm has to finance its operations. It is usually thought of in terms of being the amount of money that the farm has available to finance operations for the next year.
The calculation is, working capital equals current assets minus current liabilities.
Current assets are what the farm expects to convert into cash within a year, such as cash, accounts receivable, market inventories and prepaid expenses.
Current liabilities include the obligations that must be paid within a year. Examples include accounts payable, principal portion of long-term debt due in the next year, operating loans and advances.
Let’s assume your balance sheet is recorded Dec. 31, 2016. At that date, there will be current assets and current liabilities, as described above. “Current” is balance sheet language for the next year from, in this case, Dec. 31.
Once the current liabilities that exist at that time (operating loan, principal due for the year, etc.) are taken into account, the rest of the money is yours to use however you wish, firstly to pay the expenses for the operation for the next year.
Make sure as you calculate your working capital that you do not include current assets that you typically will not plan on converting into cash in the next year, even though they are technically a current asset. An example would be marketable securities (investments).
Working capital that is greater than the operating expenses required for the next year usually translates into cash flow, which is easier to manage.
Unfortunately, the opposite is also true, and the cash flow challenges resulting from inadequate working capital can be severe.
It’s time to do something when cash flow constraints start to negatively affect management decisions, such as missing opportunities for input purchases at lower prices or not being able to apply certain fungicide treatments.
“If you don’t like your cash flow in the present, look at your conversations in the past,” said Mike Richardson of Agility Consulting and Training.
“If you want a certain cash flow in the future, focus your conversations in the present.”
The “conversations,” or management decisions, that Richardson refers to are functions of the farm’s ability to generate profit.
Profit is the only sustainable source of cash flow, and of course, more profit will result in enhanced cash flow,
However, what if the farm has already maxed out its ability to generate profit? The “conversations” then turn to managing the cash flow that is available.
There are three aspects of cash flow:
- amount of cash flow
- timing of it
- alignment between profit and cash flow requirements
Cash outflow requirements that exceed a farm’s ability to generate profit will see working capital decrease over time. Profit margins that shrink because of production problems and/or lower prices compound the problem.
Working capital challenges can resolve themselves in situations where profit generation improves, but often management intervention is required.
There are some things you can do to improve your working capital:
- Term out current liabilities.
- Term out debt over the longest possible period, while allowing for prepayment with no penalty.
- Renting or leasing assets as opposed to purchasing.
- Purchase a share in an asset rather than a whole interest.
- Sell surplus assets, usually equipment.
- When financing the purchase of an asset, consider using the minimum down payment.
- Use interest free periods.
- Use cash advances.
- Develop and implement a rolling five-year capital budget.
- Use term debt to finance capital assets, not operating loans.
- Conduct a preliminary analysis of a farm’s income tax position.
- Timing the sale of market inventory to match cash flow obligations.
Ratios can be used to assess how sensitive a business is to changes in revenue, expense, interest rates and personal withdrawals (for unincorporated farms):
- Revenue decline ratio (cash surplus to total cash operating revenue)
This ratio indicates how much revenue could decrease before the surplus cash is used up.
- Expense increase ratio (cash surplus to total cash operating expense)
This ratio indicates how much expenses could increase before the surplus cash is used up.
- Interest rate increase ratio (cash surplus to total outstanding principal)
This ratio indicates how much interest rates could increase before the surplus cash is used up.
- Personal withdrawal ratio (cash surplus to personal withdrawals)
This ratio indicates how much personal withdrawals can increase before the surplus cash is used up.
Terry Betker is a farm management consultant based in Winnipeg. He can be reached at 204-782-8200 or email@example.com.