Revisiting the basics of these key financial indicators
Farmers know calculating working capital and cash burn rate are crucial components to understanding the financial situation of their operations. Having a good grasp of these two measures can help you prepare for lean years and assist in developing a cohesive risk management plan. However, when it comes to calculating these two measures, there can be quite a few misconceptions and mistakes. If you haven’t done so recently, now is the time to revisit working capital and cash burn rate.
What is working capital?
Working capital has a very simple definition: current assets minus current liabilities. However, it’s often oversimplified as the cash on hand for an operation. Working capital accounts for much more than just money in the bank: when working through your current assets, take stock of not only your cash on hand, but also any savings, outstanding checks from inventory that has been sold, feed, livestock, grain inventories, supplies and prepaid expenses. Liabilities to account for include all accounts payable, accrued taxes, credit card debt, payments to seed vendors (seed, fertilizer and chemical companies), any accrued interest and the principal portions of debt payment due in the next year. Working capital should function as a cushion for your farm, so understanding your working capital position gives you the knowledge and flexibility to make crucial decisions, while minimizing the risk to your operation.
Common mistakes and misconceptions when calculating working capital
The ins and outs of calculating working capital are far more complicated than a simple arithmetic problem. Farming is a complex business and it’s easy to miss a liability or an asset when trying to get a handle on your current financial situation. These kinds of mistakes can provide an inaccurate picture of an operation’s financial standing and may unearth unpleasant surprises later. Here are some common mistakes or pitfalls to avoid when calculating working capital.
Not accounting for accrued interest and other annual expenses
Depending on the loan size and payment frequency, accruing interest can represent a large liability on an operation’s balance sheet. Often these payments are scheduled on an annual or semiannual basis. Like any expense that’s only charged once a year, these payments can easily become out of sight and out mind after they are paid. Take time to go through your operation’s entire book to make sure you are planning for all expenditures throughout the year or you may overstate your working capital position.
Not accounting for current portion of term debt
Working capital is a financial indicator that is meant to measure an operation’s annual assets and liabilities for an operating cycle. While the long-term liability for any debt should not be counted against working capital, the current portion of term debt – or what’s due in the current year – should be calculated and included as a line item.
Calculating working capital at the wrong time of year
Going through the exercise of calculating working capital on an annual basis is key, but certain times of the year are more beneficial than others. A common mistake some farmers make is calculating working capital based on their projections for going to market after harvest. Depending on what actually materializes at harvest and happens with marketing, this can overstate the operation’s assets. Working capital should always be based on real numbers on a balance sheet, not predictions or forecasts. A better time to calculate your working capital position is at the beginning of the calendar year for grain farms.
Believing that working capital is “nonworking” capital
Some farmers may see working capital as money that’s simply sitting on the balance sheet and not being put to use. However, having a strong working capital position allows you to do what’s needed on your operation. Beyond the ability to secure financing, working capital is there as a cushion for hard times and as a reservoir, allowing you to take advantage of in-the-moment opportunities you may have had to pass on otherwise.
Working capital and cash burn rate
Cash burn rate is calculated after the working capital position has been determined. Take the dollar amount of the working capital your operation has on hand and divide it by projected loss for the year. For example, if your operation has $300,000 of working capital but has an annual projected loss of $100,000, your burn rate is three years. Cash burn rate is a key financial measure because it indicates whether your operation is in a position of strength or a position of challenge. During a struggling ag economy, knowing your cash burn rate aids in making key financial decisions, including whether or not to refinance loans or if any fixed costs need to be better controlled.
There are a lot of different ways both working capital and cash burn rate are measured and weighed. Some universities may recommend measuring working capital as a ratio of assets over liabilities. Farm Credit Mid-America generally weighs working capital as a percentage of gross annual income. We consider a minimum working capital position to be approximately 20 percent of an operation’s gross annual income. Ideally, your operation should have enough capital on hand to withstand multiple years of losses. At a bare minimum, your operation should have enough working capital to cover one year of loss. A solid risk management plan that includes crop insurance can help make sure you maintain your working capital position even if the season doesn’t go as expected.
Knowing your working capital position helps you make important operating decisions such as purchasing inputs or feeder livestock. If an opportunity presents itself for a down payment on capital assets or a cash discount on inputs, your working capital position influences the final decision you make. Understanding working capital and cash burn rate means having a strong grasp on the financial situation of your operation and helps to ensures its longevity.
For additional financial tips, insights and perspectives, visit the Farm Credit Mid-America website.