You may ask yourself, “Why is working capital so important?” The answer is “protection against adversity,” and with the heightened volatility pricing in commodities and input costs, having liquidity available is more important than ever. We’ve all heard the statement that "Cash is King." Working capital embodies this statement by giving you the staying power to weather adversity. Without working capital you may need to sell fewer liquid assets to meet obligations and create liquidity. Creating liquidity from sources other than earnings can be painful, because often it comes in the form of selling real estate to catch up on bills. Working capital buys you time until you can bet back on your feet or until income returns to a normal level.
The amount of working capital needed is based on the size of your operation, amount of obligations and volatility of your income stream. For example, if you have regular monthly payments from a contract source or off-farm income, you might need less working capital than someone who has seasonal grain income.
Here at Farm Credit Midsouth, we use working capital to Adjusted Gross Income (WC/AGI) as one of our core lending standards. Our threshold target is 15 percent. Dr. David Kohl, an Ag Economist specializing in Business Management and Ag Finance, is warning grain producers that their working capital needs to be increasing in the current environment. To be on the safe side, Kohl suggests maintaining something between 15 to 33 percent of revenue; and if you are conservative or desire flexibility, maintain levels above 33 percent.
Ways to build working capital:
The most preferred way to build working capital is to create earnings. Outlined below are some things to consider as you look to grow and maintain working capital during volatile times.
Minimize capital spending. Ask yourself, “Are the purchases necessary to maintain the productivity of my operation or are they done to avoid paying takes?” Avoiding taxes may not be the best strategy during volatile times. According to Dr. Kohl, “Many businesses go broke attempting to minimize taxes.” If you do make capital purchases, consider financing them instead of using cash at least until you determine your short-term cash operating needs.
Minimize interest rate risk. Look for ways to lock in the interest rate for the term of the loan or at least for a number of years to remove some the volatility.
Be careful about pre-paying intermediate and long-term debt. If you have excess cash and want to reduce debt, you may want to consider using Midsouth’s “Funds Held” product, which enables you to place up to two annual payments (additional restrictions apply on fixed rate loans with prepayment limitations) on each loan in to a Funds Held account to be used for future loan payments. You will receive interest on the account balance at the same rate being charged on the loan. You will not be able to withdraw the funds, but they will be classed as current assets when calculating working capital.
Reinvest intermediate or long-term assets into liquid assets. Take a critical look at your balance sheet for assets that aren’t working for you. Do you have what Dr. Kohl often refers to as “Killer Toys” or “Ego Purchases?” Can you re-invest the money you spent on these into more liquid assets? Sometimes it’s a hard decision, but eliminating non-essential, unproductive items can help your business in the long run.
Manage risk of production loss. Develop a comprehensive risk management plan. This should include life insurance, property/casualty insurance, crop insurance, etc. Unfortunately, unforeseen events can and do happen often without notice and at a time when stakes are high. Being caught without the right risk protection in all facets of your operation is similar to losing a leg on your three-legged stool. You stand a good chance of collapsing, and even if you are able to remain seated, it won’t be comfortable.
Additional ways to build working capital, which may be less desirable:
Restructure your balance sheet. Depending on the amount of equity you have in your assets, you may be able to restructure debt from the current portion of your balance sheet to intermediate-term or long-term notes. While this will build working capital, if corrective actions to maintain working capital are not taken and/or profitability is not improved, it will only be a short time before the operation is back in the same situation and your future choices become even more limited.
Look for equity partners. Look for cash infusions through equity partners. However, this comes at a cost, most often as a loss of control or having to answer for your decisions to a new business partner.
Sell term assets. This goes beyond the liquidation of nonessential assets and moves toward downsizing your operations. Doing this may limit your ability to take advantages of future opportunities and/or impede future growth.
There are many ways to think about working capital: it’s the rainy day fund; it allows you to farm another day; it helps you absorb the shocks or ride out the turbulence. The bottom line is it’s important to think about working capital. In today’s environment, adequate working capital will be needed for long-term success and can help take the stress off you and your operation.
Portions excerpted from “Working Capital—Why Do I Need It Now More than Ever?”
by Amy Gintner Cooney, Product Development Manager, for AgStar. Published June 18, 2009.