A significant decline in working capital in a farm operation can lead to a rapid deterioration of the overall financial outlook for the entire farm and its owners. The simple definition of working capital is total current assets minus total current liabilities. Getting true and accurate working capital data can be much more complex. Current assets usually include available cash from bank accounts, accounts receivable, grain and livestock inventories, prepaid crop and livestock expenses, hedging account balances, and any other short-term assets. Accounts receivable could include crop insurance or government farm program payments, deferred payments on grain or livestock that has already been sold and delivered, and money owed to a farm for custom or contract work.
Current liabilities include all accounts payable, unpaid taxes due, any crop input loans with co-ops or seed companies, farm operating loan principal balance, and accrued interest on all loans. The current liabilities also include the amount of loan principal payments due in the next 12 months (not the entire principal balance) on all term loans and real estate loans. In the case of grain that has been placed under CCC Loan with the Farm Service Agency, either the entire value of the grain should be listed as an asset and the loan amount as a liability, or just the estimated net value of the grain should be listed as an asset.
The financial ratio that is often used to express the level of working capital is the current ratio, which is simply current assets divided by current liabilities. A current ratio of 1.7 or higher in a farm operation is solid, while a current ratio below 1.2 is a warning sign of potential financial challenges or cash flow difficulties. If the farm current ratio drops below 1.0, it likely means there could be difficulty in paying all accounts payable at year-end, as well as repaying the entire principal balance on the farm operating loan for the previous year. In more serious situations, there could also be difficulty in paying all required loan payments on term loans and real estate loans. Ag lenders usually pay close attention to these trends.
Another ratio that many farm financial advisors and ag lenders follow very closely is the level of working capital to gross revenue in a farm operation, which more accurately reflects the liquidity needs based on the size of a farm operation. That ratio divides the calculated working capital for the farm operation by the annual gross revenue of the farm business. For example, a farm operation with calculated working capital of $200,000, and annual gross revenue of $400,000, would have a ratio of 50 percent, which would be quite strong. However, if a farm operation had a gross revenue $2 million with $200,000 working capital, the ratio would be only 10 percent, which could be a financial concern.
A working capital to gross revenue ratio of 30 percent or higher for crop farms, and 20 percent or higher for livestock farms, is fairly strong. If the ratio drops below 10 percent, it indicates financial stress, which may require some financial restructuring. If this situation occurs, it is best for farm operators to consult with their ag lender to explore some workable solutions.
Based on the Farm Business Management records for more than 1,400 southern and west central Minnesota farms, the average working capital to gross revenue ratio in 2017 was slightly above 25 percent, with crop farms averaging more than 33 percent, with various types of livestock farms averaging between 12-17 percent. The data also showed that farms in the bottom 20 percent of net income in 2017 had an average ratio near 7 percent, while farm operations in the top 20 percent of net farm income had an average ratio of more than 35 percent. There was very little difference in the average ratio among different sizes of farms, ranging from 500 acres to more than 2,000 acres.
As we enter 2019, working capital will likely be a concern for an increasing number of farmers. This is due to large variations in 2018 crop yields and year-end grain inventories, lower values for grain inventories, and increasing levels of accounts payable and farm operating loans at the end of 2018. Farm operators in the Upper Midwest with reduced crop yields last year are especially feeling some added financial stress from the decline in working capital.
Once a farm operator has identified the need for improved working capital, they should consult with their ag lender and farm business management advisors to develop a workable plan. Some possible ways to improve the working capital in a farm operation include:
Most working capital shortfalls can be worked out if they are identified early, while manageable solutions are still available.
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