Liquidity measures the ability of a business to meet financial obligations as they come due in the ordinary course of business without disrupting normal operations. Commonly used liquidity measures include the current ratio, working capital, working capital to gross revenue, working capital to total expense, and working capital per crop acre. The current ratio is the focus of this article.
The current ratio is computed by dividing current assets by current liabilities. Current assets include cash, accounts receivable, fertilizer and supply inventories, crop inventories, and market livestock inventories. Current liabilities include accounts payable, operating loan balances at the end of the accounting period, and term debt payments due in the next year on noncurrent loans, such as for breeding livestock, machinery and land.
Liquidity thresholds are typically used by analysts and lenders to determine whether a farm has an adequate liquidity position. A current ratio above 2.0 is considered adequate and would typically be sufficient to weather a one- or two-year downturn in margins. A farm with a current ratio below 1.0 is not able to cover its current liabilities by selling all current assets, and therefore may have trouble repaying loans.
Tight margins squeeze liquidity
Now let’s turn to an important question: Why is liquidity so important in today’s environment? To start with, liquidity represents a farm’s first defense against financial stress. When cash flow is tight or even negative, liquidity can be used to cover the gap or shortfall. Liquidity is also needed to replace noncurrent assets such as machinery and equipment in a timely fashion.
Along this vein, liquidity increases a farm’s flexibility. For example, farms with a strong liquidity position are in a better strategic situation to cash-rent or purchase additional land.
Tight margins since 2013 have put a strain on liquidity for many farms. Using data from the Center for Farm Financial Management at the University of Minnesota, the median current ratio has declined from a peak of 2.45 in 2012 to 1.37 in 2017. Moreover, about 70% of the farms in 2017 had a current ratio below 2.0. These farms need to be extremely cautious with their use of cash, particularly with regard to purchases of machinery, buildings and land.
A strong liquidity position helps a farm to weather cash-flow shortages and enables a farm to take advantage of opportunities as they arise, particularly if these opportunities involve asset leases and purchases. Conversely, a weak liquidity position reduces a farm’s ability to buy machinery and buildings and to cash-rent and purchase 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 the Center for Commercial Agriculture. He writes from West Lafayette, Ind.