What is Working Capital, and Why is it Important?
Working capital is one financial measurement used to assess the strength of your farming operation. It is the liquid funds a business has available to meet short-term financial obligations. A business's working capital is calculated by subtracting current liabilities from current assets.
How to Calculate Working Capital
Current assets – Current liabilities = Working capital
Current assets include cash, accounts receivable, inventories of grain and livestock, inputs or resources to be used in production such as feed, fertilizer, seed, etc., and the investment in growing crops.
Current liabilities are accounts payable, unpaid taxes, and accrued expenses, including accrued interest, operating lines of credit, and principal payments due this year on longer-term loans.
Working capital is a financial measure of your farm's liquidity. If you have sufficient working capital, you can quickly meet short-term obligations and shore up operational losses.
Why is working capital important to a farm?
If you are new to obtaining farm financing or have been in the game for a while, you’ve probably heard your lender sing the praises of working capital. They have encouraged, cajoled, and maybe even demanded working capital reach and remain at a certain level. Have they ever explained this insistence on working capital?
It is partially attributed to market volatility and risk in production agriculture. On the whole, farmers are price takers, not price makers. You rely on the whims of the marketplace to establish the price of your commodity, and the market is remarkably volatile. Let’s examine the difference between a price maker and a price taker and why that is important.
Price Maker vs. Price Taker
A manufacturer is a prime example of a price maker. A widget maker will only sell his widgets for what it costs him to make them. He sets his price based on demand, costs, and hoped-for profit. He may need to adjust his product or price, but he sets that price. Because of this, the widget maker’s cash flow is reliable and reasonably confident.
A farmer, on the other hand, is a price taker. By and large, the marketplace determines a farmer’s price. A farmer’s responsibility is to create a profit margin by controlling their input costs. However, input costs can also be variable, leaving a farm open to the whims of the market. A farm’s cash flow will vary based on commodity prices, and sometimes cash flow will be insufficient to cover costs and debt obligations. This is where working capital comes in.
How much working capital does a farm need?
A good ratio to check if you have enough working capital is dividing your working capital by either total revenues or expenses. This ratio shows what percent of expenses incurred or revenue generated could be covered internally by the business without disrupting normal operations by selling assets.
Working capital/total revenues
Working capital/total expenses
>33% strong
10-33% caution
<10% vulnerable
