Focus on Ag: Working capital still important 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. Many grain farmers in the Upper Midwest are coming off a fairly profitable year in 2021 and have more excess cash available to spend in the farming operation. While it may be tempting to spend all the extra available dollars on capital investments for the farm or for non-farm purposes, it is a good idea to continue to focus on the working capital in a farm business. Many farm operators saw the working capital in their operation drop significantly from 2017 to 2019, so there is some need to rebuild this going forward.
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 nine-month CCC loan with the Farm Service Agency, 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, 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.
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%, 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%, which could be a financial concern if not addressed.
A working capital to gross revenue ratio of 30% or higher for crop farms and 20% or higher for livestock farms is usually considered to be acceptable by most ag lenders. Many farm operators strive to have working capital levels at 40% or higher for cash flow purposes. If the ratio drops below 10%, it is usually an indicator of some financial stress in the farm business, which may require some financial restructuring. If this situation occurs, farm operators need to consult with their ag lender to explore some workable solutions.
Based on the Farm Business Management records for over 1,500 southern and west-central Minnesota farms, the average “working capital to gross revenue” ratio in 2020 was approximately 32 percent, which was an improvement from the previous five-year period (2015 to 2019). In 2020, crop farms had an average ratio just over 40%, with most livestock and dairy farms at much lower levels. The data also showed that farm operations that were in the bottom 20% of net income in 2020 had an average ratio of only 12%, while farm operations in the top 20% of net farm income had an average ratio of over 36%. There was very little difference in the average ratio among different sizes of farms that ranged, from 500 acres to over 2,000 acres.
It should be pointed out that 2020 featured the highest level of government farm program payments ever recorded making up well over 50% of the net farm income in 2020 for many farm operations, which lead to the noticeable improvement in working capital levels for the year. The expected stronger working capital levels at the end of 2021 will more likely be based of improved profit margins for crop and livestock production.
As we enter 2022, the level of working capital should be improved for farm operators in many areas of the Upper Midwest; however, working capital may still be a concern for farms that were affected by the drought in 2021 and for some livestock producers. Farm operators that carry a large amount of term and real estate debt with rather large annual payments also need to have added focus on maintaining a strong working capital position. The much higher costs of fertilizer and other crop inputs for 2022 is also likely to impact working capital by year end.
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 advisers 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 unneeded 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.
In most situations, working capital shortfalls occur a year or two after some very profitable years, as farm operators tend to invest in higher priced capital investments and farmland, as well using cash from the farm operation for non-farm purposes. Many times, this involves adding more intermediate and long-term debt that needs to be serviced on an annual basis, which can lead to cash flow and working capital issues in future years. Most ag lenders and farm business management advisers are well prepared to assist farm families with setting up a manageable strategy for working capital in their farm operation.
For additional information contact Kent Thiesse, farm management analyst and senior vice president, MinnStar Bank, Lake Crystal, Minn., at 507-381-7960 or firstname.lastname@example.org.