Through the month of January, many of our clients in the Grainews community received a request from the local banker, Hans Immapocket, for an updated net worth statement and income tax or financial statements. The banker wants these statements in order to renew the operating line of credit for the next year.
Rather than just hand over the statements, we want our farm clients to understand why the bank wants this information and how our clients can use this information themselves to make better decisions.
We also work with farm management teams to develop a formal communication plan that, like a good Clint Eastwood movie, summarizes the Good, the Bad, and the Ugly of the farm’s financial situation. We also keep the farm’s financial institution in the loop. This open communication means less misunderstanding within the ownership team or with the financial institutions.
We know you’d rather not discuss weak aspects of the business. And you’re probably wondering why in the world you would tell your banker this stuff. Well, because the banker is a critical partner in your business. In reality, the management team should focus on these weak areas and gather input about how best to manage them. Bootsauce, a wise pal of ours in university, said it’s easy to look at the pretty ones, but you better pay attention to the other ones as well since they might be your only ride home.
The next four articles will break down the ratio analysis for the good, the bad and the ugly in our Grainews community.
In this article, we’ll discuss liquidity — which deals with the farm’s ability to meet its obligations over the next fiscal period. It concentrates primarily on current assets and current liabilities.
Current assets include cash, accounts receivable, prepaid expenses, farm supplies, and commodities or market livestock that will be sold in the next 12 months.
Current liabilities include accounts payable, operating lines, cash advances, the current portion of term debt (principal payments due in next 12 months), and the current portion of lease payments.
The liquidity needed to cover meet these liabilities can vary between operations. An operation with monthly cash flow, such as a dairy or poultry operation, will need less liquidity than a grain operation that must fund 12 months of operating expenses from the current assets.
Four main ratios are used to evaluate liquidity:
1. Current ratio = Current assets divided by Current liabilities
This ratio assesses if the operation has enough assets in inventory for sale to cover the liabilities that will be due in the next 12 months. For a typical grain or beef operation, an acceptable ratio is 2:1. Value of inventory is equal to twice the liabilities. A lender has comfort at this level, so even if the price of commodities drops, the operation will still have enough to cover short term requirements.
2. Working capital = Current assets minus Current liabilities
This figure is the net investment of the owner in current assets. If negative, this number is always considered a huge weakness. If negative, it means the operation has had either production problems, price problems or management problems as the owner has structured his debt too aggressively and the operation has not been able to live up to the expectations of management.
3. Working capital ratio = Working capital divided by Projected operating expenses
Working capital ratio measures how much of the farm’s own funds will be going into the upcoming year’s production expenses and how much will be financed by trade credit, operating loan or cash advances. If the operation plans to finance 100 per cent of the operating expenses, it takes the risk that it will not be able to revolve it’s operating loan or pay down any term debt if there are any production or price problems. A restructuring in the near future is a strong possibility. The other risk associated with a low working capital ratio is that cash will likely make management decisions at some point in the year. The farm will be forced to market commodities for cash flow or will be unable to take advantage of discounted prices on inputs.
4. Debt structure ratio = Current liabilities divided by Total liabilities
This ratio looks at the percentage of debt that is considered short term. An operation with a 100 per cent debt structure ratio has all of its debt due in a very short time, which is fine if the operation has very little debt. An operation with too much debt due in a short time could be faced with income tax challenges as principle is not an expense.
These ratios are excellent business indicators, but always remember — they are just indicators. Any one of them on its own does not always guarantee a problem. Ratios should always be used as a quick measure to determine if there is a need to look deeper.
HOW TO MITIGATE WEAK LIQUIDITY
Farm managers can use ratios to assess the level of risk his operation is taking. Before meeting with lenders, take some time to think about the weak ratios and come up with mitigating factors that
offset their weakness. Some common mitigating factors to weak liquidity include:
Strong cash flow management skills. If management has a very clear and well planned projected cash flow, this mitigates the risk that a cash flow crunch will catch management by surprise.
A high level of equity gives management the option to term out some short term liabilities over a longer period of time if liquidity erodes too far.
Immediate debt service relief. If a number of loan payments will disappear during the year, this can allow the business to be more comfortable with a lower level of liquidity in the short run knowing that the funds typically used for these payments will rebuild working capital going forward.
Andrew DeRuyck and Mark Sloane manage two farming operations in Southern Manitoba and are partners in Right Choice Management Consulting. With over 25 years of cumulative experience, they offer support in farm management, financial management, strategic planning, and mediation services. They can be reached at [email protected]and [email protected]or 204-825-7392 or 204-825-8443.