Recently, I finished a three-day session with a group of highly motivated dairy producers who were committed to lifelong learning and improvement of their businesses. In fact, there were so many great questions from the group that we did not get to them all. One such question actually came from a producer’s accountant who wanted to know why working capital is deemed so important in determining the financial strength and viability of a dairy operation. While this seminar focused on dairy, this is an important question for all agricultural sectors, including grain.
The first line of defense in business is cash flow. Working capital is the second line to be used in the cases of profit or cash flow difficulties. Historically, this financial metric was often used in the grain industry, but lenders also used the current ratio (current assets divided by current liabilities) to measure financial liquidity.
Today, the sufficiency of working capital is more often measured by dividing net working capital (current assets minus current liabilities) by either farm expenses or farm revenue. While lenders still tend to use the current ratio metric, producers most often measure financial liquidity in terms of working capital, expenses, and revenue which is more straight-forward. Specifically, this ratio shows what percent of expenses incurred or revenue generated could be covered internally from the business without disrupting normal operations by the sale of current assets.
To answer the accountant’s question, historically, working capital has not been as important in the dairy industry because of its relatively stable milk prices and monthly flow of income. However, in recent years the dairy industry has seen tremendous instability and volatility in revenues from milk prices and cull cow and calf prices. There has also been a dramatic shift in expenses such as feed and cropping costs which causes shortfalls in profit and cash flow. This trend builds a strong case for working capital in dairy operations.
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Secondly, U.S milk is significant in trade with 39 percent of all U.S. milk exports currently going to Mexico. As the new Administration continues to implement change and negotiate trade, agriculture will be impacted. Agriculture trade and commodities remain long-time political tools of power. To borrow the old adage, it is prudent for every American producer to “hope for the best and plan for the worst.”
Another point to consider is the rapid growth taking place on some dairy farms. For many, this growth means high debt levels, with leveraged financials and less equity, particularly in land. In addition, when in the growth mode, Murphy’s Law often appears in the form of cost overruns, and lag time before optimal profits and cash flow materialize. Financial reserves and liquid assets are vital as a buffer or bridge to keep the business out of trouble.
Next, when examining working capital one has to determine the rate at which the capital can be turned into cash. That extra bunker full of silage, receivable for custom work, or prepaid expense in fertilizer may be current assets, but they may not be very financially liquid. My recommendation is that at least 10 percent of current assets be in cash. Some dairymen will sell extra heifers beyond normal replacements to build reserves of financial liquidity, which is also appropriate.
The economic reset is another case for financial liquidity. When going through a cyclical downturn, accounts payable can escalate quickly. This, of course, requires liquid financial assets to cover shortfalls.
Finally, whether it is dairy, grain or any other commodity, producers must have a good marketing and risk management plan in addition to crop insurance. These management practices help safe-guard against volatility in revenues or cost. Especially if these elements are absent from an operation, working capital and some liquidity are absolutely critical to the operation’s profitability and sustainability.
With these explanations, below are recommendations for green, yellow, and red light levels of liquidity in working capital for use in most any sector in agriculture.
This life-long learner presented a great question. Please note that the figures above are general guidelines. Each producer and lender must mitigate risk according to their own comfort level. Regardless of what financial practices are in place, be sure to integrate them into any operational analysis.