Long-term trends of falling prices, rising costs, and rising interest rates all point to tighter margins in the near term. Global election outcomes, military conflicts, the transition from fossil fuels to green energy, and the increasing use of artificial intelligence (AI) each impose a level of uncertainty on the future of the economy.
A business strategy for this type of economic environment with extreme and volatile prices and costs provides sufficient working capital as a backup in the event of a decline in profits and cash flow. Recently, a banker in the Midwest asked me if I could discuss my logic regarding recommended levels of working capital. I prefer to use the working capital to expense ratio rather than the standard current ratio. I think business owners and managers can understand this metric better than current ratios.
Don't forget the stop lamp!
I often discuss my green, yellow and red light levels from a risk perspective. This simple traffic light analysis shows that it is a green light if a company's working capital to expenses exceeds his 25%. What this means is that the company will finance one quarter of its annual expenses internally with working capital rather than with borrowed funds.
At the other end of the spectrum are companies in the “red light” category, with working capital to expenses of less than 10%. This means that approximately one month's worth of expenses will be covered by existing working capital. Trends in agricultural records databases over the past three years show that top-level managers maintain working capital as a percentage of their expenses at a level of 50% of his, or approximately half, annual expenses.
Replenishment of working capital
Lenders often analyze these metrics according to default risk, which is difficult to measure. Rising land prices over the past few years have made it possible to refinance debt to replenish working capital. Extended economic downturn cycles where land losses occur and capital values do not increase will result in a focus on working capital burn rates to assess risk. Losses are divided into working capital and a working capital burn rate is calculated for another level of scrutiny.
For example, if your working capital is $1 million and your farm expenses are $4 million, your working capital to expense ratio is 25 percent, or “green light.” If his losses are $300,000 or $25,000 per month, his working capital burn rate will be 3.3. As losses increase to his $500,000, his working capital burn rate falls to his 2 years. Depending on the level of loss, you can quickly move from a green light to a red light rating. Both the working capital expense ratio and the working capital burn rate should be analyzed. This is because maintaining working capital will be a priority in the economic cycle that will occur in the near future.
Working capital crisis
Of course, the size and type of company will affect the level of working capital required. Metrics can vary widely for pork, dairy, and grain companies. For example, a dairy farm may have higher monthly income and therefore require less working capital.
However, businesses that do not have a marketing or risk management plan for both their outputs and inputs will require additional working capital beyond what is considered normal to reduce risk. Finally, you should consider the quality, timing, and sale of liquid assets to meet current obligations. In the coming years, working capital and working capital preservation will be the lifeblood of many companies.
The opinions of David Kohl are not necessarily those of Farm Progress.
