Talk about the teachable moment. The current crisis within the dairy industry is lesson No. 1 on how critical working capital is to the survival of a business.
"Farmers who make it through these trying times will have most likely had the working capital needed to bridge the gaps between cash inflows and cash outflows stemming from low milk prices,” says Bruce Jones, a dairy management specialist with the University of Wisconsin.
Even now, whether producers can obtain operating loans may depend on their working capital positions, he says. Working capital, by definition, is the difference between current assets (assets that will be turned into cash within a year) and current liabilities (liabilities that must be paid within a year).
Lenders look at this ratio to determine whether borrowers are likely to have the ability to pay off operating loans within a year, Jones says. "Lenders have to get repaid as agreed, or they will get into cash flow problems themselves,” he explains.
Working capital in any business is largely a function of profitability. But whether a business retains its working capital depends on spending habits.
Some businesses use it to make down payments on large capital items, buy equipment or pay ahead on debts. If too much of this is done, the business won't have the working capital to draw on in periods of weak cash flow.
At the same time, businesses shouldn't hoard working capital either. Returns are often low on cash reserves, and using some profits to reinvest in the business should generate greater profit.
"A reasonable goal for accumulating working capital is an amount equal to half of total current liabilities,” Jones says. "This would provide the business $1.50 of current assets for every $1 of current liabilities.
"When profitable times return, dairy producers should make it a priority to replenish their working capital positions before making additional investments and/or assuming more debt,” Jones advises.