The Basics of Working Capital and Why It’s Important
All lenders have financial measures they evaluate when considering a loan application. Many of those measures include lending standards centered on the 5 Cs of credit. Those Cs are Character, Capacity, Capital, Collateral and Conditions. It is one of the components of Capital – specifically, Working Capital, that we will focus on in this article.
What is Working Capital?
The definition of working capital is current assets minus current liabilities. Items most commonly reported as a current asset on an agricultural producer’s balance sheet are:
- cash (checking and savings account balances)
- marketable securities (stock accounts, mutual funds, etc. NOT retirement accounts)
- accounts receivable (money owed to you due within normal terms)
- cash invested in growing crops (not yet converted to a harvested crop)
- crop/feed inventory
- marketable livestock (livestock expected to be sold within the next 12 months)
- prepaid expenses and supplies
These are items that you expect to convert to cash within the next 12 months.
Items most commonly reported as current liabilities include:
- operating loan principal balance
- credit card balances paid off monthly
- accounts payable
- accrued rents/taxes
- accrued interest expense (both operating line and term loan interest) and current portion of principal due on term loans
These are obligations the operation has due within the next 12 months.
In the normal course of business, producers are buying and selling goods and services all while producing a crop. In the purest sense, working capital is the measure of a producer’s ability to meet those operational cash demands within the upcoming operating cycle.
In the example balance sheet below, this producer has $100,000 of working capital. Working capital is the sum of current assets minus current liabilities. Lenders also consider the ratio between current assets and current liabilities which is called the current ratio. The current ratio is found by dividing the sum of the current assets by the sum of the current liabilities. In the above example $255,000/$155,000 = 1.64:1.00. The higher the ratio the better. This demonstrates the operation has the ability to cover its short-term obligations (those due within the next 12 months) with its current assets. While different commodities have different working capital requirements, a good standard to measure your operation would be a minimum ratio of 1.50:1.00.
Importance of Working Capital
Why is working capital so important? Having and preserving working capital is important primarily because it protects an operation against earnings adversity. This becomes especially important in times of economic disruptions such as drought, price disruptions, input cost spikes, rising interest rates, etc. When a producer faces economic disruptions, and their operation has adequate working capital, the spikes of high input costs or the lows of commodity prices can be less disruptive on cash flow. The lower the working capital ratio, the quicker the operation will need to rely upon borrowed funds to get goods to market. The converse is true in that the higher the ratio of current assets to liabilities, then the less need for outside capital to fund the crop year.
Currently we are seeing many producers impacted by drought and/or spiking input costs. While we cannot predict the future with much reliability, we can be prepared for adversity by managing the balance sheet and maintaining a strong working capital position. Having a properly managed balance sheet allows for protection against adversity and reduces the reliance on borrowed funds. What this means to the producer is less money borrowed, resulting in less interest paid and more return to your bottom line.
During times of economic duress, we often hear, “we have great equity”. While this may be true, equity does not pay the bills, earnings do. When earnings are unavailable, working capital fills the gap. While equity is a very good thing to have, it really is the “staying power” of the operation, cash is king and allows the operator to keep current on obligations due within the next 12 months. It is important to understand the different areas of the balance sheet and how to manage each.
Safeguarding Working Capital
It is very important for producers to continually monitor working capital and have a plan on how to safeguard it. What is meant by safeguarding working capital? Once an operation achieves a comfortable working capital ratio for their operation, it can become tempting to use some of the excess liquidity for other capital items, i.e., equipment purchases, improvement projects, herd expansion, etc. These are great uses of excess liquidity, but it should only be expended with a meaningful, well thought out plan to preserve sufficient working capital for unanticipated adversity. Don’t be lured or tempted into the trap of depleting your hard achieved working capital position with the promise of recharging from an anticipated great year. Remember Black Swan events come out of nowhere, and it is important to keep your balance sheet in “balance” to ensure your future success.
If you want to further discuss this or any other area of financial management, please reach out to your loan officer. If you are not currently a member of our association, please do not hesitate to contact a Western AgCredit branch near you. We would love to sit down with you to discuss and strategize ways to help you achieve success in your operation.
Want more news on this topic? Farm Bureau members may subscribe for a free email news service, featuring the farm and rural topics that interest them most!