Eye on Working Capital

Fred M. Hall, Northwest Iowa Extension Dairy Specialist, Iowa State University

Fred Hall

If you have heard my discussion on the direction of milk market you will remember one of my closing statements is that “dairymen will need to strengthen balance sheets before any real herd expansion rallies in a broad way. Some dairies are in stronger positions and are taking advantage of higher milk prices by filling their barns and moving expansion plans forward. Let’s take a look at where we are with working capital from the balance sheet in a broader way.

As with any business, working capital is the frontline defense in risk management, dairy farms are no different. Working capital is not a ratio, but real dollars, it gives a snapshot of the financial position of the operation on a particular day. Specifically, working capital is measured by taking the operation’s current assets minus current liabilities.

The USDA notes as farm incomes turned lower, so did working capital. In 2012, sector-wide working capital was more than $160 billion. For 2020, the USDA is projecting working capital will fall to $52 billion. What is the correct level of working capital, that depends on the enterprise, but it is the downward trend that is problematic for our industry.

David Widmar in Agricultural Economic Insights discusses working capital as a percentage of gross revenue.

“One way of thinking about this ratio is “for every $100 of gross revenue, how much financial cushion (working capital) is there?” The chart below shows this measure since 2012. When farm income and working capital were both high, the working capital to gross revenue ratio was 37%. More recently the ratio has been closer to 15%. In 2020, the ratio is expected to reach 12%. For every $100 of projected revenue, the sector will have only $12 of working capital. In other words, many producers will find the current portion of their balance sheet to be very tight in 2020.”

Total U.S. Farm working capital, 2012-2020. Data Source USDA ERS.

The University of Minnesota has worked with FINPACK data to determine the adequacy of working capital by computing the working capital to gross revenue. By comparing the level of working capital to a farm’s annual gross income, it puts some perspective into the adequacy of working capital.

Let’s view working capital in terms of adequacy. Are income and property taxes or living expenses listed as a current liability on your balance sheet? These expenses require working capital to cover them. Liquidity and working capital are not a measure of wealth, but if bills pile up faster than they can be paid, working capital is not sufficient.

A farmer who has a working capital to gross income ratio of 8 percent will rely heavily on borrowed operating money, because they will run out of their own working capital early in the year.

A farmer that has a working capital to gross revenue of 26 percent will rely on borrowed money during the year, but not as heavily and not as soon.

 

 

They conclude that a percentage over 30 percent indicates a strong enterprise while less than 10 percent is a fragile enterprise. Enterprises between those numbers fall in a caution range.

Again, the balance sheet is a snapshot of the enterprises financial condition on a given day and changes as business is conducted each day as bills are paid, crops are harvested and new loans established. Even as milk checks have creeped higher, repairing the balance sheet is paramount before capital expansion.

This article appears in the I-29 Moo University e-newsletter for February and is used here with permission. The author may be contacted at [email protected] or ph (712)737.4230

 

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