High Profits Boost Working Capital

October 6, 2012 03:36 PM

First line of defense against declining prices

Use virtually any financial measuring stick and the result is the same: Overall, corn and soybean farmers are well positioned to weather a correction in crop prices in the next year or two. While the drought wreaked havoc on yields, crop insurance and high market prices will come to the rescue for many crop farmers. It’s a different story for the livestock side, which is dealing with the double whammy of high corn and soybean prices and the drought.

"Corn and soybean profits have been good for so long that some producers have become  complacent about their working capital levels," says Danny Klinefelter, Texas A&M ag economist. But agriculture is a cyclical industry and high profits are not going to last forever, as cycles will eventually return, as they do for all industries.

"We used to recommend
a working capital to gross revenue ratio of 33%, but now we suggest 50%"

"The Black Swan events could be Europe and energy markets," Kline-felter adds. Such events coupled with higher interest rates could reduce land values that have been climbing for several years.

"It used to be that we recommended a working capital to gross revenue ratio of 33%, but now we suggest 50%," says Chad Hart, ag economist at Iowa State University. Current data shows farmers have a conservative working capital position of 70%, he adds.

It’s not only working capital, which is a measure of liquidity to revenue, that is strong. USDA forecasts a debt-to-asset ratio of 10.3% for producers nationwide in 2012. That’s the lowest since the department began collecting such data decades ago.

Numbers Tell the Story. Working capital among Iowa producers has increased from 40% in 2005 to 60% in 2008 and 70% at the end of 2011. As a result, farmers have had the capacity to purchase land, equipment and grain bins—a lot of it with cash.

"Working capital is the first line of defense," says Mike Boehlje, Purdue University ag economist. "It’s a shock absorber against a price or yield decline."

Retaining adequate working capital creates a conflict for producers, however. If it involves cash, it isn’t making a contribution to profit. When that cash can be invested elsewhere to make a reasonable return, farmers struggle with saving it, Boehlje says.

Risk-Absorbing Capacity. Specifi-cally, working capital is the difference between current assets and current liabilities; it’s a producer’s risk-absorbing capacity. It includes cash, commodity inventories and supplies; it does not include land or breeding stock.

Boehlje has concerns about the availability of some forms of working capital. There’s no question that cash is liquid. He notes, though, that working capital can include stock in a local co-op, which might not be readily convertible into cash.

Seed and chemical inventories for the upcoming crop are typically considered working capital. Techni-cally, they could be sold, but they would have to be replaced, so classifying them as working capital is not really accurate. "An inventory of corn is much more available than seed, fertilizer and chemicals," Boehlje adds. If producers have working capital tied up in less liquid assets, they need higher levels of inventory.

Enterprise Factor. It all comes down to risk management, Boehlje says. The more risk you have, the stronger working capital position you need. For example, farmers who are excellent hedgers can get by with a weaker working capital position, but that requires an honest assessment of strengths versus weaknesses.

Working capital recommendations also vary by enterprise. Livestock producers need less liquidity than crop producers on a percentage basis because livestock cash-flows more regularly. Cow–calf operations need to maintain a 25% working capital to revenue ratio; dairy farmers, 20%; and fed cattle operations, 15%. "Debt levels need to match the asset," notes Michael Langemeier, an economist at Purdue University.

Having a healthy amount of working capital is particularly important in commodities with wild price gyrations, Klinefelter advises. "Cotton, for instance, can be boom or bust." It’s also important for producers with high fixed costs, such as cash rent, to have stronger working
capital positions.

For producers with less than 50% equity, Klinefelter recommends an equal percentage of working capital. For those with a debt-to-asset ratio of 40% or less and 60% equity, less working capital is required, perhaps 30%. If you have share-crop land rental agreements and a 25% debt-to-asset ratio, you can get by with a modest 25% working capital.

Equally important is that interest rates will not always be at their current historical lows,  Langemeier believes. "The 10-year average for short-term rates is 9% to 10%. They could go up within the next year or two," he says.

Current solvency is very strong, Langemeier notes, but farmers need to pay attention to  long-term commodity forecasts. USDA and the Food and Agricultural Policy Research Institute project long-term corn prices of about $4.50. "Don’t plan on $6 corn," he advises.

"The position you don’t want to find yourself in is low working capital and a lot of short-term debt," Klinefelter adds.

Working Capital to Gross Revenue: 2006–2010 Average


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