Check your working capital to revenue ratio

BROOKINGS— A good first line of defense for businesses facing lower profits is to build a good working capital position, explains Jack Davis, SDSU Extension Crops Business Management Field Specialist.

“Agricultural operations need to maintain a strong working capital position to insure their ability to make timely payments, take advantage of growth opportunities and prevent liquidation,” Davis said.

Working capital is the difference between current assets and current liabilities, which are both balance sheet items. And Davis said as producers are preparing their financial statements this winter, they should evaluate the quality of their current assets, the price risk on those current assets, their working capital position, and the trend of that position.

“Strong working capital may be comprised of a large portion of cash or good quality assets that can be quickly converted to cash,” he said. “Grain in the bin is a good asset, but its quality for working capital may be subject to price risk and physical deterioration. It is important to monitor the physical quality and equally important to have a plan for converting those inventories to cash.”

Davis shared an example, where a farm’s current asset value of grain decreased $190,000-plus when holding 75,000 bushels of unpriced corn at the end of 2013 and 2012 (see Table 1). At the end of the year in both 2013 and 2012, assume this farm held 75,000 bushels of corn unpriced in on-farm storage. The value per bushel decreased $2.55 from 2012 to 2013, resulting in a decrease of $191,250 to the value of current assets.

“This decrease in current assets could put the farm at risk if there wasn’t a corresponding decrease in current liabilities,” he said.

The capital required to grow crops has increased substantially in recent years, Davis explained, so he said it is important that producers correspondingly increase their working capital position.

“The ratio of working capital to gross revenue is one way to monitor the adequacy of an operation’s working capital. This ratio measures the percentage of gross revenue that is available in working capital to meet expenses,” he said.

Calculated as working capital divided by gross revenue, a higher ratio indicates a better working capital position. So, Davis said, the higher the ratio, the less a producer may have to borrow to meet operating needs.

The trend in the working capital to gross revenue ratio for South Dakota farms is presented in Figure 1.The high return farms average for the past five years was $0.53 with a range of $0.47 to $0.58.

“This is a strong ratio, but the sharp decrease from $0.59 to $0.48 in 2011 to 2012 is concerning,” Davis said.

He explained that drop is likely due to the drought in 2012, and the average 2013 ratio for these farms is expected to rebound when the data are available in May 2014.

“The average return farms had a working capital to gross revenue ratio of $0.46 during this time period, ranging from $0.40 to $0.52. These farms also had a very strong ratio, but with a decrease from 2011 to 2012. The low return farms averaged $0.30 with a range of $0.18 to $0.45,” he said. “While this range dips into the troublesome area, it did trend higher from 2011 to 2012. This ratio is important to monitor for all levels of return as poor liquidity may lead to additional financial stress.”

The revenues, current assets, and current liabilities listed below provide example data for calculating the working capital to gross revenue ratio. The farm has the following gross revenues, current assets, and current liabilities:

Working capital is $337,500 (current assets of $537,500 minus current liabilities of $200,000). Working capital divided by gross revenue equals 33.8 percent ($337,500 / $1,000,000).

“A working capital to gross revenue of 30 percent to 35 percent is considered strong. The cautionary range is at 15 percent to 20 percent,” Davis said. “If this ratio falls to less than 13 percent the farm is at risk of not being able to meet its current debts as they come due. Failing to meet current payments may quickly deteriorate to being unable to secure needed capital and liquidation.”

He said that problems may arise when large amounts of cash are used to finance capital purchases or the purchases are made with short term financing.

“Assume that the farm above has financed a capital purchase and will be paying an additional $200,000 in principal for the current year. What happens to working capital? The working capital to gross revenues ratio falls to 13.8%. (($337,500 – 200,000) / $1,000,000). This puts the farm’s working capital in a marginal position,” Davis said.

Ways to improve working capital:

1. Finance capital purchases over a longer period of time allowing you to build up working capital.

2. Invest in working capital first.

3. Reduce withdrawals for personal living expenses from the farm.

4. Do not use the operating line of credit to finance capital purchases. It reduces liquidity and you may not be able to refinance the equipment at a later date.

5. Diversify by making investments outside the farm on a regular basis may provide additional income when farm income is depressed.

For additional information on farm financial measures and trends of South Dakota farms, visit iGrow.org and check out this link: http://bit.ly/1hFPION.