Farm Management Minute: Working Capital
Many farms are in loan renewal season with their lending institutions and the term working capital will be a part of that conversation. So, what exactly is working capital? The equation is simply balance sheet current assets minus balance sheet current liabilities. In more simple terms, it is the amount of money left after you sell current assets and pay off current liabilities.
Current assets are the ones that will be sold or turned into cash in the next 12 months. For an ag producer, these would consist of grain, market livestock, feed, growing crop, prepaid inputs, and accounts receivable. Current liabilities are the offset to these assets and are how they are financed. These would include accounts payable, operating line balances, accrued interest, input financing from a vendor, as well as principal and interest payments due on your intermediate and long term loans within the next 12 months.
For example, if you have $500,000 in current assets and $250,000 in current liabilities, you would have $250,000 in working capital. If you project that you will have $1,000,000 in expenses for the year and you have $250,000 in working capital, this means that you can pay for 25% of your expenses with your cash and the remainder will need to come from some sort of financing.
Why is working capital so important? Basically, the stronger the working capital is, the less reliant you are on your lender and the better prepared you are to withstand tougher times. If your budget this year shows that you are going to lose money, that loss will be absorbed by your working capital. In the example above, if you lose $50,000, it will reduce your working capital from $250,000 to $200,000. No one wants to go backwards, but that is one of the reasons to maintain strong working capital, to be prepared for just such an occasion.
Over the past few years, working capital has been decreasing as commodity prices remain low. Another hit to working capital has come from reduced crop yields due to the flooding and extreme moisture levels and livestock loss from extreme weather events during calving. All of these events affect the working capital available to producers for the next year. Farms with large amounts of equipment and land payments also can struggle with working capital, as the annual payments can be quite large which decreases the available working capital.
Hopefully, this article helps explain the whys and hows of working capital. Managing working capital is one of the many things that we focus on with our clients in the South Dakota Center for Farm Ranch Management. We analyze the financials and work with your lender to help make sure your balance sheet is structured properly. If you would be interested in working with our program to help you better track and manage your finances, please contact one of our instructors at 1-800-684-1969 or firstname.lastname@example.org.
–South Dakota Center for Farm Ranch Management.