Beyond a bank balance

February 25, 2014

What’s the right level of working capital for your farm? It probably isn’t what you think

Posted Feb. 12, 2014  by  in 

Working capital can be a harsh indicator of liquidity. On a practical level, it tells you how much you’ll have on hand to buy operating inputs for next season. It’s your ability to get next year’s crop in the ground or to feed animals in the lot — before you need to tap into an operating loan.

For many grain and oilseed farmers, what used to be a worry line has become a source of pride.

But is a big working capital number really such a good thing?

Well, you could start by talking to anybody who has had to survive with limited working capital (which is most of us at some point in our careers). Depending on the bank for 80 to 90 per cent of crop expenses in a year can be difficult and stressful.

As a farm’s working capital increases, there’s more flexibility in marketing, negotiating, getting discounts and acquiring capital assets.

However, there’s a sweet spot for every farm. If you have too much working capital, your cash isn’t working hard enough. If you have too little, you don’t have an adequate buffer against risk.

“Working capital is like the lifeline of a business,” says Craig Bremner, vice-president of TD Canada Trust.

The amount of net working capital needed for any business varies depending on size and cash flow. Grain and oilseed farmers have a lot of variation within the year, and their pre-paid expenses and storing crop can dramatically change cash flow, while businesses with consistent, predictable cash flow, such as supply management, require less working capital.

For some agribusinesses, including grain elevators, maintaining strong working capital is critical. They need to continually deal with the ins and outs of their customers, and they must be positioned to make the most of here-today, gone-tomorrow market opportunities.

A strong working capital position also eases the tension on farm marketing, helping you be more patient, and it also enhances your ability to purchase discounted inputs. “Having working capital allows you to be opportunistic,” Bremner says.

Working capital can also allow for some pre-buying and tax planning. However, Bremner warns if pre-buying ties up too much cash, it may be better to balance it with some temporary financing.

This buffer should be used for short-term expenses and not be kept and used to buy long-term assets. Don’t dip into working capital to leverage acquisitions of land, says Bremner. “You should buy short-term assets with short-term loans or working capital.”

It may seem counterintuitive to have money sitting in a low-interest account when it could be generating income in an appreciating asset, but tying up all your extra liquidity may leave you unable to buy land when and if land prices ease off.

Typically, only 75 to 85 per cent of land value can be financed, says Bremner.

“Cash is king,” says Mike Bossy, president of Bossy Nagy Geoffrey Group Chartered Accountants in southwestern Ontario. “You can make profits and have good return on investment, but can you still keep paying all your bills?”

The most common error Bossy sees with managing working capital is paying for fixed assets out of cash flow, such as farmers pulling the deposit for equipment replacements out of working capital.

“Stop buying equipment out of cash flow,” Bossy urges. “Get a loan and then if you have extra at the end of the year, make extra payments on that loan.”

A strong working capital and equity position going into the next few years should help with three potential changes: sustained lower commodity prices, levelling real estate prices and increases in interest rates.

Pulling working capital down the balance sheet limits buying opportunities later. “Ask yourself what opportunities would exist if interest rates doubled?” advises Bossy. “That’s where they were five years ago.”

Track it

To calculate working capital, add up all current assets that will last less than one year, such as cash, crops growing in the field, inventories and receivables, and prepaid expenses. Salable assets not held for resale, such as fall-applied fertilizer, farm supplies and feed are not included.

Then simply subtract current liabilities, such as accounts payable, accrued interest, principal payments and loans due within the next year, notes payable to banks, wages and taxes payable, and your current portion of any long-term debt payments.

Bossy says most farmers have their accountants calculate working capital on their year-end financial statement only, and very few recap their current assets and current liabilities on a regular basis. It becomes more difficult to sort out with cash, not accrual, accounting.

Comparing your own farm’s working capital over several years tells a powerful story. If it’s decreasing, what’s going on. Is it low profits, or is the structure of the debt depleting working capital? Or is it something else?

As a quick reference point, Bossy suggests farmers divide their total cash expenses by 12 months and then see if they have enough current assets to cover three months of expenses. He’d even take it a step further and do a spreadsheet of monthly projected cash flow, and then compare that to actuals.

“Tracking working capital is a great tool to monitor the health of your business, the liquidity,” Bossy says.

Working capital is not only cash but also includes assets that can be turned into cash in 12 months, and it also gives a picture of what expenses are up ahead. Most often current assets are receivables and inventory. “Not very often do I see cash on the balance sheet,” says Bossy.

Benchmark

When stress-testing a balance sheet, lenders and economists love to look at net working capital divided by gross revenues. Then you can compare between various sizes of operations.

Last year, David Kohl, agricultural economics professor emeritus at Virginia Tech and founder of AgriVisions, crunched this ratio from data of about 1,200 farms on the Minnesota farm management education programs, and found the working capital to gross revenue ratio averaged 36.8 per cent.

Not surprisingly he found as profitability increased, farm balance sheet liquidity improved too. When divided by gross farm revenue, there was very little difference by age of farmers but the larger farms generally had lower working capital ratios.

The precarious position of some of these farms shone through Kohl’s work. Farmers with more debt maintained less working capital. Those in his data base with a debt-to-asset ratio higher than 80 per cent had only three per cent working capital to revenue. Those with less than 40 per cent and less than 20 per cent, had ratios of 53 per cent and 73 per cent working capital to revenue, respectively.

Generally, after several years of good yields and commodity prices, the talk about working capital has shifted. “Most farmers have a more comfortable level of working capital and a buffer this year,” says Pierre Robitaille, director and group lead at Scotiabank in Listowel, Ont.

Profits have been reinvested to make farms more efficient, adopt new technology and grow. Any extras are being invested in things like RRSP, RESP, AgriInvest and other non-farm investments, says Robitaille. “Primary producers are becoming more sophisticated investors, pulling advice from accountants and financial advisers.”

 

Knowledge. Clarity. Action.