Working capital, or liquidity, is one of the most important metrics that a business should track. Working capital is computed by subtracting current liabilities from current assets.
Current liabilities include operating loan balances at the end of the accounting period, and term debt payments due in the next year on noncurrent loans. These include loans for breeding livestock, machinery, buildings and land.
Current assets include cash, fertilizer and supplies on hand at the end of the accounting period, crops held for sale and market livestock inventories. Raised and purchased calves and feeders, raised and purchased pigs, as well as other nonbreeding livestock inventories, should be included in market livestock inventories.
Though working capital by itself is an important liquidity measure, it is often more relevant to measure working capital in relation to gross revenue or on a per-acre or per-livestock-unit basis. You could also measure it against value of farm production. These adjustments make it possible to make comparisons across different farm sizes and over time for a farm that has been aggressively expanding.
Why working capital matters
So why is working capital so important in today’s environment? To start with, working capital represents a farm’s first defense against financial stress. When cash flow is tight or even negative, working capital can be used to cover the gap or shortfall.
Working capital is also needed to replace machinery and equipment, and to make down payments on land. It increases a farm’s flexibility in making these capital decisions. With respect to land, a strong working capital position puts a farm in a better position to cash rent or purchase additional ground.
A stoplight analogy can be used to establish benchmarks for the working capital-to-gross revenue ratio. A working capital-to-gross revenue ratio below 0.2 would be in the red region. A ratio between 0.2 and 0.35 would be in the yellow region, and a ratio above 0.35 would be in the green region.
The working capital-to-gross revenue ratio for U.S. farms has declined significantly during the last decade. In 2010, the ratio was 0.43. By 2015, the ratio had dropped to 0.19. The projected ratio in 2019 is only 0.13. Clearly, the low ratios exhibited in the past few years are concerning.
Recent studies reveal large differences in working capital among farms. For example, working capital to value of farm production for farms in the Great Plains that had a ratio below and above the threshold level of 0.35 was 0.15 and 0.83, respectively. For farms with a value of farm production of $500,000, this amounts to a difference in working capital of about $340,000.
This article briefly discussed why working capital is so important. A strong working capital position helps a farm withstand cash-flow shortages and enables a farm to take advantage of opportunities as they arise, such as adding a key employee or family member, or leasing or purchasing additional land. More information pertaining to financial management can be found on the website for the Center for Commercial Agriculture.
Langemeier is a Purdue University Extension agricultural economist and associate director of Purdue’s Center for Commercial Agriculture.