Recently, a lender in one of my classes raised an excellent point. He questioned whether recommended burn rates on working capital should vary depending on enterprise. For example, would the recommended burn rate be the same for a specialty crop operation and for a grain operation? What about hogs, dairy, poultry, livestock and others?
The first step is to define the burn rate on working capital. The simplest method is to use the top half of your balance sheet. Add up all the current assets, and deduct current liabilities. The resulting number is working capital.
If your farm is projected to generate a negative profit, divide the working capital by your projected annual loss. This determines your burn rate which is also the number of years before you burn through your working capital. For example, if a farm has $500,000 in current assets, and $250,000 in current liabilities, then the working capital is $250,000. If the losses (actual or projected) were $125,000, the burn rate would be 2 or two years ($250,000/$125,000 = 2).
A burn rate above three years is considered strong, but a rate below one year is weak. In answer to the lender’s question, considering today’s economic market volatility, uncertain global markets, and shifts in consumer demand and market preferences, this benchmark holds fairly well across all enterprises.
Often, lenders working in the poultry industry respond that long-term contracts with steady income negate the need for working capital. That statement is true; however, in recent years, sudden shifts in demand, Avian Flu and international sanctions have placed those contracts in jeopardy. Thus, a working capital reserve can be very useful in allowing more time and flexibility to make adjustments, even in the poultry business.
Another consideration for my lender friend is the quality of current assets. This can impact the level and strength of the burn rate. For example, if the current assets are all in cash or extremely liquid assets, a lower burn rate may be acceptable. However, current assets such as inventory or crops in the field may require a higher burn rate. Additionally, if those crops have no risk management plan, the needed rate may increase again.
The size of business is also an important factor. According to University of Minnesota’s Center for Farm Financial Management FINBIN database, farms in the lower 20 percent of profitability with annual revenue above $2 million, lost over $300,000 in profits in 2015. The working capital of businesses on this scale can burn as fast as rocket fuel.
As a side note, analysis of the FINBIN data from the Center for Farm Financial Management used working capital to revenue as a measure of resiliency. This metric showed the resiliency rate of crop farms is nearly double the rate of livestock farms. It seems that recent years taught many grain farmers the importance of working capital as a financial shock absorber.
In conclusion, while the type of enterprise is a consideration, the specifics of the individual business are more important in determining the best burn rate on working capital. Factors such as business size, financial data and management practices will more likely determine profitability, not the enterprise.