February 25, 2020
It’s been said that in business, “cash is king.” In the financial world, your cash position is referred to as liquidity.
Liquidity is defined as “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 agricultural business, yet it may have a heightened significance depending on what you produce, how long it takes you to produce it, and how it’s 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 either a “current ratio” or “quick ratio.”
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 the quick ratio as a key indicator of a business’s ability to meet short-term obligations, since inventory is not always able to be quickly converted to cash. This is especially true in operations where inventory may take a long time to be sold — nurseries, wineries, orchards.
When liquidity is important
Liquidity’s importance in your operation’s overall financial picture depends on a few factors.
First, if your operation is small with low inventory and operates primarily on a cash basis, cash flow may be regular and frequent. In this case, liquidity is not as much of an indicator of financial health since cash availability is more consistent throughout the year and money is not tied up in receivables or inventory.
In a larger, more inventory-heavy operation, liquidity takes on greater significance as an indicator of financial health. For example, a crop grower who buys inputs in March but doesn’t get paid until that crop is marketed in the fall needs to account for bills due during 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 influencing liquidity
In industry sectors like agriculture, 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 operating expenses and debt.
Another factor that can have considerable influence on liquidity is the stage an operation sits in its overall life cycle. An established, more 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.
Good practices to remember
It’s a good practice to have approximately six months in operating expenses available to your firm, either in cash or in a line of credit with a lender. This may need to be adjusted up or down depending on your business and its revenue cycle.
Be disciplined with lines of credit and pay them off when your revenue comes in. This will keep those funds available for when you need them again.
Liquidity gives a business options: Businesses with adequate liquidity are able to take advantage of early pay discounts, negotiate favorable buying opportunities, and are better-positioned for investment or expansion when opportunities arise.
Inventory will make your balance sheet look good, but it’s hard to pay bills with inventory, especially if that inventory is slow to sell.
Inventory is a necessary evil for many businesses. It can consume a lot of cash, and if it’s things like plants or livestock it can require significant maintenance. Managing inventory — as much as you need but as little as you can get away with — can be critical for many businesses.
What’s the bottom line?
Liquidity is a key financial variable to watch, regardless of the structure of an agricultural business. It’s important to balance maintaining strong, short-term liquidity against opportunities for higher profits, and in the broader context of making sound business decisions.
Laughton is Farm Credit East’s director of Knowledge Exchange.
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