How Much Working Capital Do Dairymen Need?
Source: Ken Bolton, University of Wisconsin Extension
Traditionally, farm business managers have received direction from financial advisors to maintain at least a 1:1.5 Current Ratio in order to weather periods of deficit cash flow. The logic behind the recommendation is that the business manager who is able to generate $1.50 in cash/near cash inventory within the current year for each $1 of current liability should be able to meet business obligations for a period of time without disrupting normal business operations, i.e. sell off assets to generate cash. But given this recommendation, how long might you able to do so?
Farm business managers experienced significant financial distress during 2009. The negative effect of this economic downturn on cash flow and profitability was unparalleled in recent history. From the experience it became clear that standard thumb rules for Current Ratio and general guidance for Working Capital were not adequate in addressing long-term, significant financial stress. So, in preparation for the next change in milk price, “What is it going to take to not only survive but thrive?”
Working Capital is the absolute dollar amount of money left after turning current assets into cash and paying off current liabilities. Because of variations in size, expenses, income and leverage between businesses no pat, specific recommendations can be made as to the absolute number of dollars needed for all farms to remain current on obligations.
However this does not mean an amount cannot be determined for an individual business to use for planning purposes given historic financial data and user defined projections for the future. Perhaps a better minimum level of Working Capital will be equal to one year’s family living expenses plus debt payments.
Others are recommending the retention of 30 percent of total annual expenses in cash and operating loan borrowing capacity. Still others suggest an amount equal to recent cash shortfalls, total purchased feed cost or interest expense or perhaps an absolute $500 per cow. Some strive to maintain at least 20 percent Working Capital: Gross Revenue. The most likely level you choose is the one that makes you most comfortable heading into the future.
Let’s clarify that the recommendation to maintain a Current Ratio of 1.5:1 is a MINIMUM recommended level and, additional emphasis needs to be placed on the concept to “maintain” this minimum level of available cash. A wider Current Ratio lowers the risk a downturn in prices received or an uptick in prices paid for inputs will result in severe financial stress. Likewise, 2009 underscored the fact that a minimum Current Ratio is not sufficient for most businesses to continue to pay current obligations for more than a limited period of time. Perhaps a good general goal is to build savings and credit reserves that may be used when cash flow is deficient.
What actions are recommended? Retain as much cash as possible during times of good financial performance. Build borrowing capacity by paying down, if not off, Accounts Payable, Taxes and Principle due. Don’t allow short-term borrowing and the associated “short term” interest rates of 18% or greater to turn into a long term, ballooning liability. If you can’t pay them off, seek to refinance these loans at a lower interest rate with your lender to minimize the cash flow demand high interest rates have on short term loans.
Build equity and borrowing ability. Before paying ahead on term loans seek an understanding, if not an agreement, with your lender that if cash becomes short in the future you will be able to borrow operating funds against your newly acquired equity. Also, collect Accounts Receivables.
The Cash Flow Statement records/projects both income and expenses on an annual or monthly basis. Few farm businesses have consistent inflows and out flows of cash from month to month due to volatile commodity prices and input costs. A farm business’s past history is the manager’s best guide to planning for the future. Even during typical years, specific months may be identified when cash flow may be negative and plans can be made to address the shortfall.
Adding a sensitivity analysis of different “what if” scenarios of higher and lower price combinations adds value to cash flow planning. For example, what if input costs increase 25-30% while milk prices decline by 40% in the next year? The impact on potential cash flow can be identified with a Cash Flow projection.
