A few weeks ago I was in Ames, Iowa, addressing the Farming for the Future Conference with a very attentive audience of lifelong learners. One of the attendees sent me some very important follow-up questions after the conference. “What components are included in working capital? Is a farm’s operating line of credit one of them? You recommend working capital guidance of at least 33% of gross revenue. Is gross revenue taken from past years or cash flow projections?” I am glad he asked these questions because similar questions are frequently asked by producers.
By definition, working capital is current assets, which can be turned to cash in one year or less, minus current liabilities due within one year. Working capital measures financial liquidity, which is the ability to sell assets without disrupting normal business operations.
Current assets include cash, crops growing in the field (often valued at the cost of inputs or the level of crop insurance), and inventory, i.e. corn and soybeans in the bin or livestock to be sold. Marketing plans including options or hedging contracts can be valuable in ascertaining inventory value. Accounts receivable that are collectable and prepaid expenses, i.e. fertilizer, feed, rents, etc., are also current assets.
On the current liability side, accounts payable, i.e. feed, fertilizer, repair or vet bills, etc., and accrued expenses, that is, wages and taxes payable are included. Also, principal reduction of intermediate and long-term debt due within the next 12 months is included.
Finally, to address the question on the operating line of credit as part of working capital, here is an example. If the line of credit is $500,000 and $250,000 has actually been drawn upon, $250,000 is the amount that would be listed as a current liability. The line of credit limit would not be listed as a current asset. The amount of the line outstanding is often used to generate eventual income by the sale of current assets, i.e. crops growing in the field or raised livestock.
Concerning the question about 33% of revenue as working capital, a trend analysis is valuable in some cases going back 3 to 5 years to determine working capital position. When the industry is in the positive part of the economic cycle, the working capital percentage should increase, such as the current state of the livestock sector. The opposite is true when the cycle is waning, such as the current grain sector. Should working capital be tested against cash flow, income, and revenue projections? Absolutely. This provides a futuristic view of your business’ liquidity. This analysis would be very relevant for businesses considering expansion and utilizing debt, so an adequate financial shock absorber can be accumulated in case of a worst-case scenario.
The subject of working capital will be an important point to cover with your lender during renewal season this winter.
For more from Dr. Kohl, follow his "Road Warrior" blogs.