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What is working capital, really?

Erica Louder for Progressive Forage Published on 29 November 2018

Before we really dig deep into these questions, let’s take a look at a football team. It will make sense later, I promise. This clever concept is credited to David Kohl, professor emeritus at Virginia Tech University and popular instructor on agriculture finance.

It’s an analogy that compares the defensive lineup on a football team to the sources of repayment on a farm.

Think about a football team. What is the first obstacle for the team on offense? It’s the defensive line, right? If the goal line is your operation, the defensive line is your cash flow. When cash is coming in at a sufficient level, you can keep the offensive team (suppliers, bankers, etc.) paid.

If your cash flow is strong, you meet your obligations and your farm grows. Cash flow is the first source of repayment and the first line of defense.

What is the second line of defense in football? It’s the linebackers, right? Think about what makes a good linebacker. They are strong, fast and react quickly. They stop the ball when the defensive line is weak. Linebackers are like working capital.

If working capital is available and strong, it can shore your operation up when cash flow is weak. If you don’t have cash to meet your obligations, your working capital goes to work. It is the secondary source of repayment and the secondary line of defense.

The final line of defense in football are the safeties. They play an important role, but they serve the purpose their name describes. They provide a safety net when the ball moves past your defense. They stop the progress before things get out of hand – but in a last-ditch effort. In farm finance, the safety is your farm’s equity.

It is critical to build equity but not what you want to rely on for repayment. When losses are incurred, and working capital runs out, you save your operation through your farm equity. It is the third and final line of defense and the last source of repayment for your debt.

This analogy provides a great visual to consider the financial strength of your farm and gives us a background on working capital. Let’s dig into some details now.

What is working capital?

Working capital is one financial measurement used to assess the strength of your operation. Michael Langmier, professor of agriculture economics at Purdue University, gives us a great by-the-book answer. He says, “Working capital is the liquid funds a business has available to meet short-term financial obligations. The amount of working capital a business has is calculated by subtracting current liabilities from current assets.” Take a second to consider that definition.

If you don’t know what assets and liabilities are considered “current,” he clarifies his definition by adding, “Current assets include cash, accounts receivable, inventories of grain and livestock, inputs or resources to be used in production such as feed, fertilizer, seed, etc., and the investment in growing crops.

Current liabilities include accounts payable, unpaid taxes, accrued expenses, including accrued interest, operating lines of credit and principal payments due this year on longer-term loans.”

In a nutshell, working capital is a financial measure of your farm’s liquidity. It is your ability to quickly meet short-term obligations and shore up operational losses.

Why is working capital so important to a farm?

You’ve probably heard your banker sing the praises of working capital. They have encouraged, cajoled and maybe even demanded working capital reach and remain at a certain level. Have they ever explained this insistence on working capital?

Bill Lickley, relationship manager for Northwest Farm Credit Services, says, “Working capital is a number one in my book. With the current state of the agriculture economy, I can’t stress it enough with a customer.”

Why this kind of insistence? It is partially attributed to, like Lickley says, the economic condition of agriculture. On the whole, farmers are price-takers, not price-makers. We have to rely on the whims of the marketplace, and the marketplace can be remarkably volatile.

In the common accounting class example, a widgetmaker will not sell his widgets for less than it cost him to make them. He will set his price based on demand, his costs and hoped-for profit. He is, in effect, a price-maker. At times, he will have to adjust his product or price, but he sets that price. Because of this, the widgetmaker’s cash flow (remember, the first line of defense) is reliable and fairly certain.

A farmer, on the other hand, is a price-taker. The marketplace determines a farmer’s price. Whatever the board or the sale barn says calves or crops are worth that day is what is paid. A farmer’s responsibility is to create a profit margin by controlling their input costs. But input cost can also be variable, leaving a farm again open to the whims of the market.

A farm’s cash flow will vary based on commodity prices. Sometimes that cash flow will be insufficient to cover costs and debt obligations. This is when working capital should come into play.

How much working capital do I need?

Kohl says, “The sufficiency of working capital is often measured by dividing working capital by either farm expenses or farm revenue. This ratio shows what percent of expenses incurred or revenue generated could be covered internally from the business without disrupting normal operations by the sale of current assets.”

Figure 1 is a guideline for the working capital-to-expenses ratio. Kohl suggests you aim for these metrics but take into account your own comfort level (and that of your lender) when it comes to risk.

Guideline for the working capital-to-expenses ratio

With these thoughts in mind, think about your own operation and maybe compare it to a football team. Is your cash flow covering all operating expense and debt? What happens if prices drop? Is your working capital sufficiently strong to bolster you? Compare it to the ratios above. Then consider your farm’s equity. If it comes to it, is there enough to keep your farm afloat?

At your next bank meeting, come prepared with answers to these questions. Make a plan and present it to your banker. Relationship manager Bill Lickley says, “Don’t let your loan officer be your CFO. Be proactive in your approach and knowledgeable about these ratios. Know where your issues are before your lender does. This will build your credibility, and to the bank you will seem a safer bet, even if times are tough.”  end mark

Erica Louder is a freelance writer based in Idaho. Email Erica Louder