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Do you know how to measure liquidity?

Follow simple strategies to see how much cash you have on hand.

May 31, 2024

4 Min Read
Money growth concept image of coins and dollar bills with soil and leaves sprouting above
MEASURE LIQUIDITY: Liquidity is important to any farm business, but it may have heightened significance depending on what you produce, how long it takes to produce it, and how it’s being sold or marketed. Aleksander Tumko/Getty Images

by Chris Laughton

It’s been said that in business, “cash is king.” In the financial world, your cash position is referred to as liquidity.

What is liquidity? It is “the ability to immediately cover debt obligations or expenses with cash or assets on hand.” In other words, liquidity is your ability to pay your bills.

Liquidity is important to any farm business, but it may have heightened significance depending on what you produce, how long it takes to produce it, and how it’s being sold or marketed.

Business owners often look at their balance sheet to assess their financial position, but long-term assets such as real estate can’t pay today’s expenses. This is where liquidity comes in.

How do you measure liquidity?

Liquidity is often measured by using the “current ratio” or “quick ratio” method. The current ratio is comprised of all current assets, including inventory, compared to current liabilities. The quick ratio takes inventory out of the equation. It’s made up of cash and other assets that can be quickly converted to cash compared to current liabilities.

Lenders consider quick ratio as a key indicator of a business’s ability to meet its short-term obligations, since inventory is not always able to be quickly converted to cash. This is especially true of operations where inventory may take a long time to sell, such as nurseries, wineries or orchards.

When is liquidity important?

This depends on a few factors. First, if your operation is small with low inventory and operates primarily on a cash basis, then cash flow may be regular and frequent. In this case, liquidity is a less important indicator of financial health because cash availability is more consistent throughout the year and money is not tied up in receivables or inventory.

In larger, more inventory-heavy operations, liquidity takes a greater significance as an indicator of financial health.

For example, a crop grower who buys inputs in March but doesn’t get paid until fall should account for bills coming due in the growing season. A nursery operator with considerable working capital tied up in planted trees or shrubs should also watch liquidity closely, considering the time and work required to sell that inventory and turn it into cash.

Factors that influence liquidity

The importance of inventory puts a premium on closely managing liquidity. Without doing so, an otherwise healthy-looking balance sheet can be misleading if the business is going to rely on product inventory to pay for operating expenses and debt.

Another factor is where the operation is in its overall life cycle. An established, mature operation will likely have fewer capital requirements compared to a newer, growing business because of the required investments for buildings, machinery and equipment as the business grows.

Regardless of size or what is produced, a downturn in market prices is a time when liquidity takes on greater significance. Low crop prices, for example, put greater pressure on cash flow than when prices are strong.

7 ways to monitor liquidity

Liquidity is a key financial variable to watch. It’s important to balance strong, short-term liquidity against opportunities for higher profits and in the broader context of making sound business decisions.

Here are seven strategies that can help you monitor liquidity on your farm:  

1. Monitor cash flow. Forecast, budget and track inflows and outflows to anticipate liquidity needs. You may also want to use cash-flow projects to forecast future cash needs and surpluses, and control costs during periods of low income.

2. Manage inventory efficiently. Use inventory control methods to minimize storage time and balance supply with demand. Technology may be helpful to keep track of inventory. This is important for inventory-heavy farm businesses such as nurseries, wineries and farms with crops in storage.

3. Smart debt management. Align payment schedules with seasonality. Maintain target debt levels and refinance when beneficial.

4. Diversify income streams. Generate income from various enterprises or ventures to offset seasonal dips.

5. Secure adequate financing. Plan capital structure and loans to fund growth and new investments. Use operating credit lines for added flexibility.

6. Invest strategically. Invest extra cash in liquid instruments such as money markets or mutual funds for easy access.

7. Build an emergency fund. Maintain a liquid cash reserve to handle unexpected events or capital calls.

The key to putting these strategies into action is accurate records. Strong record-keeping provides a holistic view of your business to ensure you stay on track.

Laughton is director of Farm Credit East's Knowledge Exchange. This column originally ran on the Farm Credit East website. 

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