I just finished teaching at the 14th annual National School for Experienced Ag Lenders in Spearfish, South Dakota. This year's group of 70 ag lenders and regulators was very open-minded and eager to learn, which was a blessing to all the instructors involved with the school. One student asked the following question, which is very relevant to lenders and the producers whom they serve.
Question:Regarding the working capital to gross revenue ratio, do you think it would be accurate to use a three-year average on gross revenue? I normally like looking at revenue and net farm income on a three-year average to see where borrowers are on an income basis. Would using the three-year average in this scenario inappropriately adjust the liquidity picture of the operation?
Response:I would analyze each year individually, and then you could use a three-year average as another round of analysis. Using spreadsheet software, this analysis would be very easy to do.
I think a top priority should be to analyze any ratio utilizing a three- or five-year trend, versus an average. Concerning working capital to revenue, I would suggest that the gross revenue be accrual-adjusted for inventory, receivables, and normal culling of breeding livestock, if applicable. If one just uses values on tax records without adjusting for changes between the beginning and end-of-period balance sheets, revenue distortions can alter the interpretation of the working capital ratio.
Examining the three- or five-year trend, look for large deviations in revenue and working capital levels. If the producer’s operation has wide variation from year to year, it is suggested that higher levels of working capital to revenue be maintained as a safety net, but also to capitalize on potential opportunities.
This student’s question sparked my interest in net farm income trends, as well. Again, I would recommend an accrual adjustment on prepaid expenses, accrued expenses/supplies, and accounts payable between beginning and ending values on the balance sheet. If the accrual adjusted net farm income has wide variation from year to year, higher levels of net working capital to revenue are suggested.
In both the gross revenue and net farm income cases, if the farm or ranch is carrying a heavy debt load, then higher levels of working capital should be maintained. Some lenders would like to see net working capital greater than the sum of two years of the biggest farm business losses.
After the market bounce on corn, soybeans and other commodities because of the drought and with the world economy slowing, working capital will be the first line of defense for any producers and lenders.
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]