Each fall, I teach an agricultural finance course using a textbook, “Financial Management in Agriculture,” written by Professor Peter J. Barry and others. This text is special to me because it is the book I studied from as a student of Prof. Barry’s.
One of the main points made in the book is that financial goals have three elements: profitability, risk, and liquidity. Profitability and risk are the more familiar elements of financial management. Certainly, increasing profits and reducing risks are fundamental goals of every manager. Liquidity, however, tends to be forgotten or downplayed because many people wrongly assume it is a less-important part of meeting financial goals. However, that is not the case.
Why it’s important
Liquidity is the ability to access cash to cover anticipated and unanticipated expenses. Liquidity increases when cash holdings or cash-like assets — marketable inventories, accounts payable, etc.— rise. And, conversely, liquidity declines when cash on hand or current assets decrease. In addition, liquidity rises and falls as current liabilities — those liabilities due within a year — change. Liquidity increases as current debts fall, and it decreases with each increase in current liabilities.
Liquidity is the resource used to cover operating losses in years when either selling prices or production levels fall below what is needed to generate profits. Liquidity is also the resource used to purchase replacement capital or at least make the down payment on capital purchases financed with credit.
The primary source of liquidity for a firm involves surplus operating returns, which are the cash returns that exist after required debt payments are deducted from net cash income. In order to generate and build liquidity, a business must first be profitable, and then it must keep its annual debt repayment commitments at levels below its annual cash profits. If these things occur, liquidity will increase.
Use it to gauge your outlook
Dairy producers making their plans for the year should take a hard look at their liquidity positions. They must determine if there is enough liquidity to engage in some expansion activities this year or if they should wait and build up liquidity for future use. Working capital — the difference between the value of current assets and current liabilities — is the measure that dairy producers should check to determine if they have an acceptable liquidity position.
Dairy producers with working-capital balances that equal or exceed 20 percent to 25 percent of the total cost of an expansion project probably have enough liquidity to go forward with the project. The reason for this is that producers with this level of liquidity should be able to withstand a couple of years of low earnings and still be able to make good on their loan repayment commitments by drawing down their working capital.
Producers also should hold onto some liquid financial resources so that they can withstand periods of low profits or periodic production losses. Unfortunately, we never know when hard times will occur or how long they will last. That means we can only guess how much working capital we need.
One thing that is known, however, is that some liquidity will be needed from time to time. Therefore, a good financial manager makes sure that liquidity is given as much attention as profitability and risk.
Bruce Jones is a professor of agricultural economics and an extension farm management specialist at the University of Wisconsin.