Equipment continues to grow in size and sophistication, but it still needs oil and grease to keep the wheels turning and cropping operations on time. No matter how sophisticated your business has become, working capital is to your financial engine what oil and grease is to your tractor. In the short run, it keeps things moving when market prices aren’t supporting operating costs or expenses are incurred before crops are marketed.
Working capital is determined using your balance sheet, and is defined as:
(Current Assets) – (Current Liabilities) = (Working Capital)Current assets are cash or assets that are readily converted to cash. Grain inventory, market livestock or accounts receivable meet this definition, while equipment and breeding livestock do not. On the other side of the balance sheet are current liabilities or the things you use current assets to buy, like fertilizer, fuel, chemicals, feed, etc. A benchmark used to indicate a good or “safe” working capital position would be expressed as a ratio of 1.50 to 1.00 or greater.
Unfortunately, you may have more bills than cash to cover them. This can be a short term problem as is the case when suppliers need to be paid before you are prepared to sell your crop. In this scenario an operating line of credit can provide working capital on an interim basis until the income is realized and the line can be repaid. If poor market prices, growing conditions, or one of the many variables that can negatively affect profitability persist and you incur operating losses, then a longer term solution may be needed. This is where the strength you have built elsewhere on your balance sheet can come into play. If during times of strong earnings the business has accumulated assets at a pace faster than you accumulated debt, net worth should have grown both in real dollars and as a percentage of your total assets. No one likes to move backwards, but if earnings are weak or negative it may become necessary to use some of the net worth you gained to spread the loss out over two or three years. A new loan to “replenish” working capital with “reasonable” repayment terms can be considered. A “reasonable” repayment term is different for every business depending on how strong your equity position is and the duration of losses. It is never too early to have discussions with your lender and plan how you will address working capital deficiencies.
Keeping an eye on working capital and building it during strong market cycles helps avoid using your net worth during weak cycles. Risk mitigation strategies, like crop insurance and marketing plans, help take the valleys out of earnings cycles and can preserve working capital, making it last longer over prolonged downturns. This keeps you from dipping into net worth and turning a short-term problem into a long-term debt. Understanding the function of working capital, and then monitoring and managing it can help you retain your earnings and grow your balance sheet—not to mention avoiding the untimely breakdown of your financial engine.
Daniel Gitter is a vice president of commercial lending for GreenStone Farm Credit Services.