Think only your lender or accountant needs to know your dairy"s working capital level? Think again.
Working capital is one of the key measures of your business" liquidity, and your knowledge of this financial factor can help you manage your business better. And, exploit special offers that can make your dairy hum.
Suppose your feed supplier called with an offer of $1 per bushel corn. "If you"ve got adequate working capital, you can tell him to deliver it as soon as he can get the truck to your farm," says Steve Zimmerman, a farm business and tax consultant with GreenStone Farm Credit Services based in Escanaba, Mich. "If you don"t have the working capital, the offer is enough to make you cry because you know you just lost out on a fabulous opportunity that may not appear again soon."
You may have used your checkbook as a monitor of working capital in the past, but it does not provide an accurate picture of what"s going on in your business today. That"s because a checking account does not reflect accounts payable, accounts receivable or several other current assets and liabilities that influence working capital.
With that in mind, use these steps to determine your working capital.
1. Working capital defined
Put simply, working capital is the amount left after current liabilities are subtracted from current assets. It"s the amount of money you have to cover your operating expenses, manage risk and take advantage of opportunities.
And while it sounds comparable to cash flow, working capital is not the same measure.
Working capital includes cash, but it also includes other current assets — those items that can be turned into cash within a year. This includes items like accounts receivable, feed inventories, prepaid expenses and other current assets.
On the liability side, the equation also encompasses items due within the year, such as accounts payable, notes due within a year, the current portion of term debt, income taxes, the current portion of deferred debt and other current liabilities.
2. Use your balance sheet to calculate
Now that you know what you"re measuring, the next step is to calculate how much working capital you have. The information you need is found on your business" balance sheet.
All you"re going to do is subtract the current liabilities on the top right-hand side of your balance sheet from the current assets on the top left- hand side of your balance sheet.
Total current assets $300,203
Total current liabilities $225,917
Working capital $74,286
(These figures are taken from the sample balance sheet on this page.)
Just remember that the figures you use to determine current liability and asset value must be consistent and complete — listing all current assets and current liabilities. When you created your balance sheet, you assigned a base value to each asset, such as cows, feedstuffs, equipment and buildings. That value must be realistic — cow value should reflect your rearing cost for heifers to freshening, for instance. And while these figures do vary between farms, they shouldn"t stray too far from industry norms.
Also, these values should be fairly constant from time period to time period, and should only be changed when market conditions change significantly. This uniformity gives a measure of your true financial picture. Changing values offers a measure of inflation, which isn"t what you"re after here.
"The type of balance sheet you prepare, whether cost value or market value, will make a difference in calculating working capital," notes Mark Kapsner, dairy business analyst with Ag Star Financial Services in Mankato, Minn. "In general, a market-based balance sheet that"s prepared consistently will present the most accurate picture of your working capital position. Consistency is key."
3. How much is enough?
After you"ve determined how much working capital your dairy has in its coffers, it"s time to evaluate what the figure means. Adequate working capital takes the pressure off of paying bills and affords your dairy the opportunity to operate freely within your business plan.
Experts say you need at least 30 days of cash flow coverage to deal with loan principle and interest obligations. And $200 per cow in working capital is a good starting point to be able to meet these responsibilities.
To determine how much working capital you have per cow, divide the total amount by the number of cows on your dairy.
Working capital: $200,000
Number of cows ÷1,000
= $200 per cow
"Two hundred dollars per cow in working capital is adequate if you have no payables on the liability side of the balance sheet," says Gary Sipiorski, president of Citizen"s State Bank of Loyal in Loyal, Wis. "Dairy operators in any state will need this much operating room."
A more in-depth measure of working capital estimates that you"ll need more than $600 per cow in working capital to keep your business running smoothly. This calculation says working capital should be one-third the "value of farm production," defined as total gross sales minus the cost of goods sold, including purchased feed.
Below is an average calculation assuming a 305-day lactation per cow.
A 200-cow herd would then need $132,800 of working capital to fulfill this measure.
However, your lender and accountant may recommend and require a different level than either of these figures. And, working capital levels can vary throughout the year.
"It will be very difficult for a traditional dairy business to maintain a specific level of working capital all year long — especially during times of crop growth and low feed inventory," says Zimmerman. Conversely, he cautions, a large dairy may have a difficult time of ever achieving that measurement, especially if notes and mortgages are scheduled for shorter terms and feed is purchased just in time and no inventories of feed are ever procured.
Develop and maintain good working relationships with lenders and investors to be sure everyone is on the same page regarding this measure of your business.
"Many times it is a covenant within the loan agreement as to how much working capital is necessary and when it will be monitored," says Anthony DeRose, executive vice president of Wells Fargo Bank in Visalia, Calif.
Adds Marvin Hoekema, a dairy business consultant with Dairy Strategies, LLC, based in Visalia, Calif., "Working capital fluctuates substantially, as most businesses I know do not store away cash at year"s end. That said, if we are monitoring monthly or quarterly, we can equate this back to the amount of cash reserves we have in the business. We suggest that 5 percent of operating receipts be matched to period expenditures."
Watch for red flags
Finally, you didn"t calculate this figure to never look at it again.
Use it to know whether you can actually buy that $1 corn if the call ever comes, or be better able to ride out the ups and downs of this roller-coaster milk market.
Since working capital is a moving number, work with your advisory team to use this analysis as a basis for action — especially if working capital falls below desired levels.
Some critical areas to evaluate if that happens include: escalated accounts payable — which has been a particular problem this year — inadequate cash flow relative to cost of production and fixed asset purchases.
Also, take heed if you are selling long- or mid-term assets like cows and heifers to get cash to supplement working capital. If that happens on a regular basis, then you need to examine your management and make a change in how you do business. Or perhaps it"s time to consider partial, if not full, liquidation.
"As soon as a bill is over 30 days, producers should be asking themselves some hard questions," notes Sipiorski. "It would be nice to hear from them with a phone call before things get too far out."
Above all, keep in mind that this measurement only provides a snapshot of your financial picture. It doesn"t predict the future, so it can only be used as a measure of what has already occurred on your dairy. However, attention to this detail can help you get ahead of potential threats to your business and improve your financial management and performance.
How often should you calculate working capital?
Now that you realize how important working capital analysis is to your business, how often should you evaluate it?
If you raise your own crops, then you should take a look at working capital on an annual basis. "That way, you"re not unfairly penalized for crops not yet harvested," says Steve Zimmerman, a farm business and tax consultant with GreenStone Farm Credit Services based in Escanaba, Mich.
That"s not to say you shouldn"t analyze working capital more often, especially if your business is structured differently than a traditional dairy. "The level of monitoring really depends on what the business is trying to do and how critical the monitoring process is," says Marvin Hoekema, a dairy business consultant with Dairy Strategies, LLC, based in Visalia, Calif.
He recommends a monthly evaluation for businesses going through a material change in investing, financing or operating activities — like an expansion or construction that accompanies a modernization. Additionally, businesses facing liquidity issues should also take a look at working capital each month.
Meanwhile, a quarterly working capital analysis is helpful for operations with relatively stable investing and financing activities.