The other day a producer asked me an interesting question. With all the emphasis on working capital and cash lately, how much should you keep on hand? First, we must ask some specific questions. In this case, the farmer indicated that he would need a $1 million operating line of credit to purchase inputs for his 1,400-acre farm. Next, discussion focused on the lender’s advance rate. In this case the lender would loan up to 70% of the value of the producer’s assets on inputs for the operation. The lender requires the borrower to come up with 30% to margin the loan.
Margin = 30%
Operating loan = +70%
Total needs = 100%
A simple equation can assist in determining the amount working capital needed to support a given operating loan.
Loan amount x (1 - Advance rate)= Working capital needed
$1,000,000 x 30%= $428,571 Working capital
If the farmer needs a $1 million operating loan, multiply the loan amount, in this case $1 million, by 1 minus the advance rate, or 30%. Divide the result by the advance rate of 70%, and this results in $428,571 of working capital needed to margin the operating loan of $1 million. If this farm has $1.2 million in total revenue, a combination of corn and soybeans, the ratio of working capital to total revenue would be approximately 36%.
In a second scenario, if the business added 600 additional acres requiring a $1.4 million line of credit, the need for working capital generated internally would significantly increase. For example, if the advance rate remains the same:
$1,400,000 x 30%= $600,000 Working capital
In this case, the internally generated working capital would need to increase from $428,571 to $600,000.
It is important to note that this formula only calculates the amount of working capital needed to margin a given operating loan. Additional working capital would need to be on hand to weather market volatility, grow the business, make capital expenditures or take advantage of opportunities as they arise.
This simple format can be useful for those seeking to grow their business. Working capital discipline can be an important bridge in this strategic decision. This working capital pool can be built by properly allocating profits to working capital in anticipation of future needs.
Editor’s note: Dave Kohl, Corn & Soybean Digest trends editor, is an ag economist specializing in business management and ag finance. He recently retired from Virginia Tech, but continues to conduct applied research and travel extensively in the U.S. and Canada, teaching ag and banking seminars and speaking to producer and agribusiness groups. He can be reached at [email protected]