Today’s ag environment shows commodity prices are below break-even for some operators, while barely budging the break-even level for others. Economists have referred to this situation as “a grinder effect.” Meaning, the profitability level is grinding away at working capital little by little.
Ultimately, this effect impacts the efforts needed on the expense side of your business. Farm businesses who operate with a hands-off mentality and lack of insight into their numbers leave themselves open to risk and missed opportunities.
One of the biggest areas of exposure is in working capital (i.e., having enough capital to accomplish the goals for your business). When it is sufficient, working capital can facilitate your success, and when it is deficient, the lack of working capital can be a liability.
The skinny on working capital
The textbook definition of working capital is “current assets minus current liabilities.” This difference—working capital—tells a manager, a banker or an analyst your ability to operate, to pay bills and to attain your business goals.
Working capital is a necessary component of the farm operation because it helps ensure stable cash flow for day-to-day operations. It also enables the business to weather unforeseen calamities, such as major crop losses, and facilitates your ability to grow and secure credit for purchases and expansion.
Working capital doesn’t have to be cash. It can be livestock or crops. It can be accounts receivable or contracts for delivery. Or it might be in the form of liquid farm or non-farm assets. You also create working capital when you reduce short-term debt relative to assets.
Making working capital work for you
It’s hard to say how much working capital is best because every farming operation is different. But if the baseline for the financial and operational health of your farm business is the foundation, and the operational plan for your farm is the blueprint for success, then working capital is the materials. How we use the materials depends on your goals.
A good working capital plan:
- Determine sufficient working capital, and any adjustments. You and your team should have targets in mind, both on a running monthly basis and for one-, three- and five-year milestones. If it looks like you are way ahead or might fall short, take steps to adjust. Depending on current and future goals, this could be a year to preserve capital, or it could be a year in which we infuse more capital into the operation. You should have an idea of what is sufficient working capital for your near-term and longer-term needs. And you should have a plan of how to adjust as you go.
- Analyze your burn rate. A helpful analysis is your farm business burn rate. Burn rate refers to the rate at which working capital is used up over time. At times you may appear to have adequate working capital measured by a current ratio, but the burn rate tells you how fast you are using up your cash.
- Assess current working capital, then forecast ahead. Your accountant should be telling you what is happening right now or what just happened. Then applying forecasting and analysis.
- Perform predictive modeling under multiple scenarios. A financial professional can perform predictive modeling to determine the likelihood of various scenarios and the impact of changes in input costs, prices and other variables.
With these scenarios in hand, and the knowledge of the working capital your business needs, you will be better equipped for success.
Contact a K·Coe Isom AgKnowledge expert with questions, or for help with the assessment and risk management of the financial and operational health of your business.