It’s no surprise that as farms get larger and more complicated, they need more working capital. There must be money available to handle large expenses, and to manage your way through cash-flow swings brought about by volatile commodity prices.
Besides, in an era when it is so costly to grow or expand, it’s prudent to have more cash on hand for when an opportunity does arise.
The question is: What level of access to cash is right for you, and how do you monitor it?
Working capital is easily defined, says John Molenhuis, business analysis and cost of production specialist with the Ontario Ministry of Agriculture Food and Rural Affairs. Simply add up your current assets, then subtract current liabilities.
“Current assets” are all assets in cash or easily converted to cash, inventories and prepaid expenses.
“Current liabilities” in this context are due that year, including operating lines and the portions of loans that must be paid in that time frame.
“It shows you how much is available to pay what per cent of your expenses,” Molenhuis says.
Calculating working capital can give you a metric that helps to monitor your operational health.
Larry Martin calls it “current ratio”: the ratio of current assets over current liabilities.
“I don’t think about working capital as much as the current ratio, and what I tell people is that you should be looking at a current ratio of two times assets versus liabilities,” says Martin, a principal of Agri-Food Management Excellence, and a long-time consultant to farms and agriculture businesses on financial management.
Farmers not directly exposed to commodity price risk, such as those in dairy farming who have a priced product to sell every day (and therefore more regular cash flow) can get away with a lower current ratio and lower working capital.
Poultry farmers are in between. They have a product they have to grow before they are paid, but they have predictable pricing because of supply management.
Sharon Ardron, a farm management specialist with Manitoba Agriculture, also has a background in financial lending, so she brings to the discussion some understanding of the influence that banks have on working capital.
She also likes using current ratio as a good and easy measure of the health of working capital in a farm business.
“It’s a buffer against bad things,” says Martin. “The more you have the better.”
Martin says he had a client who forward contracted all his durum wheat to be graded No. 1 or No. 2, but in that particular year, none of his crop graded that well.
Yet he had a very healthy current ratio of 16 to one at one point, so he was able to work through the situation. Other farms with less working capital would have been at greater risk.
This past year, the early snowfalls on the Prairies provided a good example, Martin said at the time. “Guys are having a huge problem. They can’t get into the fields to get canola to fill contracts. These are the kinds of risks they are running this year.”
Be proactive in a year like that one on the Prairies. Ardron says a temporary bulge on an operating line of credit may be necessary, and a $250,000 operating line of credit may need to move up by $75,000 for a couple of months, until the crop is off and can be sold. She advises talking to a lender before trouble arises.
Volatility in the red meat markets was also challenging in late 2016. Farmers with more working capital will have more flexibility to weather the declines in prices and take advantage of rises in prices.
Not having enough working capital can also limit short-term profit opportunities.
Molenhuis uses the simple example of an identity-preserved soybean contract that becomes available at planting and looks good for your farm. IP soys usually require more inputs, but if there’s not the working capital available, then the opportunity can be missed.
How much working capital do you need?
So what’s the number? How much working capital does a modern commodity-producing farm need?
Extension documents in Canada and the U.S. talk about a 25 per cent working capital buffer, but Martin and Molenhuis both say that as farms face larger risks, more working capital is needed, closer to 35 or 40 per cent.
“Because market prices are so volatile and input costs are rising all the time, we’re suggesting a higher buffer,” says Molenhuis. “Thirty-three to 35 per cent is a better buffer in case corn prices really tank, so you have some reserves in there.”
Ardron says that working capital needs vary so much among different commodities that identifying one percentage is challenging. Instead, a farm business needs to identify what that number should be based on the commodity they are selling on that farm, and they need to monitor it.
She also warns that working capital needs to increase along with farm size. “Sometimes farms grow at an explosive rate and they almost get starved for cash, and then it becomes hard to meet their obligations in the short and medium and long term.”
But it isn’t only fast-growing farms that get in trouble. A farm that grows slowly can have the issue creep up on them, suddenly finding that they hadn’t been paying enough attention to the way their working capital needs were growing.
Make it a regular part of your financial management to monitor your working capital, Ardron recommends. And if your accounting systems or skill set doesn’t allow for that, then fix it.
“Maintaining good financial records is the base of it all, with good quality data and timely data,” she says.
Some farms will be required by their lending institution to provide financial health ratios. Knowing those ratios will also help with day-to-day management of working capital.
“All producers need to plan diligently for their working capital,” Ardron says, if not for their own understanding, then to make sure their operating line is at the right scale for the number of acres being cropped.
Monthly monitoring is likely enough, she says, although the ability should be there to check when needed, especially around periods when there are bills due and crop has not yet been sold.
Martin says he sees a large variation in working capital on farms, as measured by the current ratio.
If you don’t have enough
If you don’t have enough working capital, what do you do?
Refinance, take short-term debt over longer-term, and liquidate assets, says Molenhuis. That’s not where any farm wants to be, but when working capital gets too low, you will likely have little choice but to find ways to generate more of it.
On the other hand, maintaining health and growing working capital will mean the opportunity to invest in opportunities when they arrive, whether that be more land or other business growth and diversification.