The current ratio tells us whether a farmer or rancher will enough money to cover their debts in the next year.
The current ratio is one of the important liquidity ratios which helps farmers and financial analysts determine whether a farm or ranch can meet short-term loan obligations.
Current Ratio Formula
Current Ratio = Current Assets ÷ Current Liabilities
This article is a part of our series on Farm Financial Performance Ratios.
Description
In agricultural accounting, the current ratio is a farm financial metric used to evaluate the liquidity and short-term financial health of a farm or agricultural operation.
Calculating the Current Ratio
The current ratio is calculated by dividing the total current assets by the total current liabilities.
Current Ratio = Current Assets ÷ Current Liabilities
- Current assets typically include items such as cash, accounts receivable, inventory, and other assets that are expected to be converted into cash within a year.
- Current liabilities are obligations due within the same time frame, such as accounts payable, short-term loans, and other debts maturing within a year.
Both of the current assets and current liabilities can be found on an agricultural balance sheet.
Guided Example
Say for example, John, a farmer, has total current assets of $50,000 including cash, accounts receivables and crop inventory which will be sold in the next year. Also assume that he has $20,000 in loan payments and wages he owes to his employees.
To calculate a current ratio, start by taking our formula:
Current Ratio = Current Assets ÷ Current Liabilities
Then plug in the current assets and current liabilities:
Current Ratio = $50,000 ÷ $20,000
Using our formula, we arrive at 2.5x as the current ratio.
2.5 = $50,000 ÷ $20,000
What this tells us is that John has enough assets which can be converted to cash in the next year to cover his known liabilities due in the next year 2.5x over. This is good!
Ideal Current Ratio for Farmers & Ranchers
For agricultural businesses, where cash flow can be variable highly variable. This is due to factors like seasonal fluctuations in crop yields, weather conditions, and market volatility.
As such, maintaining a healthy current ratio is crucial for ensuring financial stability and the ability to manage operational expenses and debt obligations effectively.
Ideally, the current ratio should be at least 1, meaning that there are ample assets to cover liabilities in the short term. If there are not enough assets to cover liabilities in the short term, then the farmer or rancher runs the risk of being in default of their debt obligations.
To create a margin for safety, farmers should strive to have a current ratio of at least 1.3x to 2.0x. Anything higher than 2.0x means the farmer or rancher is excellent condition to meet their short term obligations.
A higher ratio indicates that the farmer a greater amount of financial resources to meet short term obligations coming due in the coming year.
How to Improve Your Current Ratio
To improve your current ratio, your strategy should be aimed at either increasing your current assets or decreasing your current liabilities.
Here are some strategies you can consider:
To Increase current assets:
- Focus on building up cash reserves by retaining profits, reducing unnecessary expenditures, and implementing cash flow management techniques.
- Streamline your inventory processes to minimize excess or obsolete inventory, which ties up cash. Efficient inventory management can reduce holding costs and free up working capital.
- Implement strategies to shorten the collection period for accounts receivables. Offer discounts for early payments or incentivize prompt payments to reduce the average collection period.
To Decrease current liabilities:
- Negotiate longer payment terms with suppliers to delay outgoing payments, thus extending the timeframe for settling accounts payable.
- Consider refinancing short-term loans with longer-term options to reduce the portion of debt due within the next year, thus lowering current liabilities.
- Manage operating expenses. To do this, start by reviewing and optimizing your operating expenses to identify areas where costs can be reduced without compromising productivity or quality.
How the Current Ratio is Used
The current ratio is a crucial financial metric used by agricultural businesses, as well as businesses across various industries, to assess their short-term liquidity and financial health.
Farmers and Ranchers us the current ratio to understand the overall health of their operation. If the current ratio continues to grow, that is a sign of a healthy operation that is able to meet short term needs!
Lender use the current ratio to assess the ability of a farm or ranch to meet their short term obligations. If a farmer is unable to pay their debts due in the next year, there is risk of default. Conversely, farmers and ranchers borrowing from a bank may get preferred or better rates when the lender knows there is greater certainty of repayment.