The working capital ratio tells us whether a farmer or rancher will enough money from the most liquid assets to cover their debts in the next year.
Working capital 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.
Working Capital Formula
Working Capital = Current Assets – Current Liabilities
This article is a part of our series on Farm Financial Performance Ratios.
Description
In agricultural accounting, the working capital ratio provides a more conservative measure of liquidity by excluding inventory from current assets. It assesses the company’s ability to meet short-term liabilities using its most liquid assets. It is calculated by dividing quick assets (current assets minus inventory) by current liabilities.
Please Note: The working capital ratio is very closely related to the current ratio, however, the drawback with the current ratio is that not all current assets can always be assumed to convert easily to cash every year. For this reason, it is more conservative to take inventory out of the equation, because this may spoil or never sell.
Calculating Working Capital
The working capital ratio is calculated by subtracting total current liabilities from total current assets. This results in a dollar amount.
Working Capital = 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.
Guided Example
Say for example, John, a farmer, has total current assets of $75,000. Also assume that he has $20,000 in loan payments and wages he owes to his employees.
To calculate a working capital ratio, start by taking our formula:
Working Capital = Current Assets – Current Liabilities
Then plug in the current assets, inventory and current liabilities:
Working Capital = $75,000 – $20,000
Working Capital = $55,000
What this tells us is that John has enough assets which can be reasonably expected to convert to cash in the next year to cover his known liabilities due in the next year as well. This is good!
Ideal Working Capital for Farmers & Ranchers
Ideally, the amount of working capital ratio should be at least enough to cover upcoming debts due within one year. In other words. there should be 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.
As such, maintaining a healthy working capital ratio is crucial for ensuring financial stability and the ability to manage operational expenses and debt obligations effectively.
To create a margin for safety, farmers should strive to have a working capital 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.
How Farmers Can Improve Their Working Capital
To improve your working capital ratio, your strategy should be aimed at either increasing your current assets, better managing inventory turnover, or decreasing your current liabilities.
Here are some strategies you can consider:
To Increase current assets:
- Increase cash reserves. Focus on building up cash reserves by retaining profits, reducing unnecessary expenditures, and implementing cash flow management techniques.
- Improve Marketable Securities Position. Build an additional reserve of marketable bonds and securities. This has the added benefit of diversifying your revenue stream.
- Accelerate accounts receivable collections. Implement strategies to shorten the collection period for accounts receivable. Offer discounts for early payments or incentivize prompt payments to reduce the average collection period.
To Improve inventory management:
- Reduce Inventory When Possible. Things like crop inventory can be sold on the spot market or future market to lock in revenue.
- Streamline your inventory processes. Minimize excess or obsolete inventory, which ties up cash. Efficient inventory management can reduce holding costs and free up working capital.
To Decrease current liabilities:
- Negotiate better payment terms. Negotiate longer payment terms with suppliers to delay outgoing payments, thus extending the timeframe for settling accounts payable.
- Refinance short-term debt. 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. Review and optimize your operating expenses to identify areas where costs can be reduced without compromising productivity or quality.
How Working Capital is Used in Farm Financial Analysis
Working capital 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 working capital ratio to understand the overall health of their operation. If the working capital ratio continues to grow, that is a sign of a healthy operation that is able to meet short term needs!
Lenders use the working capital 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.