Could you operate for a year on your cash reserves?
June 20, 2014
The past few years in agriculture have been more lucrative than any other time in history. During this time of unprecedented income, farmers have had the opportunity to improve their balance sheets, but have they? The quick answer to this would be yes, most did. However, there were some who simply used the new-found wealth to go on a spending spree purchasing depreciable assets or non-farm (family living) expenditures, often financed with borrowed money. Most of the capital purchases were made out of motivation to save on income tax, however when this is done completely with borrowed money, it seldom shows any net improvement to the balance sheet. Those who did enhance their equity position on their balance sheet likely did so by reinvesting profits into the operation. This likely included building cash reserves as well as using cash for down payment on machinery and real estate purchases.
As farm expenses have continued to increase, hopefully your working capital or liquidity has grown in stride. Cash farm expenses on the average operation participating in the South Dakota Center for Farm/Ranch Management at Mitchell Technical Institute (MTI) in 2013 were $870,865, nearly an 80 percent increase over 2007 expenses. Working capital averaged $400,977 in 2013, which was 46 percent of cash expenses. This ratio is adequate as most lenders prefer working capital or liquidity in excess of 40 – 50 percent of annual expenses. In other words, if you have cash to cover 50 percent of your annual expenses, that means you could cover approximately 6 months of expenses and current loan payments without relying on borrowed money.
Though 40-50 percent is a good start, some producers have determined that they do not want to see a repeat of the past, particularly what happened in the 1980s, so they prefer to operate with an entire year of cash reserves. This logic has proven to be quite successful to producers and has allowed them to be more competitive in a challenging industry. Having the excess cash to cover an entire year's expenses gives the producer a great deal of flexibility with marketing and purchasing decisions. Having the cash may allow a producer to take advantage of early pay discounts on inputs or more beneficial terms on capital or real estate purchases.
So, how do you build your cash reserves? My first suggestion is to manage, but pay your fair share of income taxes. These need to be looked at as a cost of doing business just like seed or feed. My second suggestion is to budget and be conservative with family living expenses. Excessive spending here can quickly deplete cash reserves. Third, though it may sound odd, but I suggest borrowing money. When you purchase intermediate or long term assets, the loan term and tax depreciation should match the useful life of the asset. Though you may have the ability to pay cash for a piece of farm equipment, it can be beneficial to not deplete cash, rather simply making the appropriate down payment, typically 20 – 25 percent, and financing the remaining amount. With today's historically low interest rates, this is a great way to lock in a low fixed rate for the 5 year term. Finally, the last suggestion is to consult your financial "team" before making any purchasing and financing decisions. This team should include your accountant, your banker, and your farm management advisor at MTI.
If you would like further information on what the farm management program can do for your operation, please contact an instructor at the South Dakota Center for Farm/Ranch Management at 605-995-3098 or firstname.lastname@example.org. F