At the start of a new year, a typical and prudent management activity for most farm operators is to reflect on the past year and examine what went right, and what went wrong. This “look-back” is focussed on looking for areas of improvement in their business and also alignment with tax season.
Though such a “look-back” exercise usually involves a comprehensive review, the focus of this article is on a very basic part of the financial position for any farm operation, but yet is also an area that is greatly misunderstood and often described in error. I am referring here to cash. On the surface, cash is a simple asset, arguably the simplest asset.
In the world of business, cash is just one of the many assets a farmer needs to manage. With the help of some basic financial management principles and insight from producer clients that I have worked with in the past, the remainder of this article focuses on the following: defining cash, understanding your short-term capital position and possible solutions for managing cash related problems.
First, let’s dispel some myths and address some often-asked questions. Does profit equal cash? Not really. A producer can grow a crop that is worth more than the expenses, but that does not mean the producer has cash. Does net worth mean you have cash? No, the result here is that a farm operator may just have more assets than debt.
So what is cash? I define it as actual cash in the bank account and assets that will become cash within one year. In the accounting world, this category is called current assets. This category of assets includes grain on hand, deferred grain tickets, pre-purchased inputs like fert/chem/seed, market livestock and accounts receivable. The measurement used to determine the adequacy of cash is a working capital calculation.
To determine your working capital, add up all of your current assets and subtract your current liabilities. This category of liabilities includes lines of credit, trade credit like at the fertilizer dealer or fuel dealer, cash advances, and all loan payments due in the upcoming year.
After subtracting current liabilities from current assets, the resulting figure is working capital. The next question is, how much working capital is adequate? Well, more is always better but a place to strive toward is to have enough working capital to pay 50 per cent of your farm expenses.
This level of working capital results in quite a comfortable financial position when we consider an actual farm operation. With all loan payments included in current liabilities, this working capital position means that you could pay all of your outstanding bills, make all of your loan payments and pay half of the bills in the upcoming year without even growing a new crop. Now that would be a comforting thought for most farm operators.
So what happens if your working capital is not that high? What are the consequences? What can be done? Well, the answers to these questions depend on the nature and severity of the problem.
If there is any level of working capital, the result then is that residual cash exists after paying all of the bills from the previous year. In some years for some of my clients, this would be considered a bonus. In my area with production challenges due to excess moisture, sometimes having any working capital is a success. The challenge with low working capital is a lack of flexibility. For example, a farm operator with low working capital is likely not able to hold grain for extended periods and hope for better prices. Such an operator is also not likely to participate in pre-purchasing lower priced inputs. A probable result is that such an operator has higher interest costs due to a greater reliance on operating debt. This operator would still be able to farm, but just might not be able to manage their business exactly to their liking due to limited financial flexibility.
With negative working capital, a whole new set of challenges are introduced. Farm operators will likely have to pick winners and losers in this case. For example, some suppliers and/or creditors will get paid while others will have to wait. A common way to try and correct this situation is with a cash injection.
So how can a farm operator increase working capital? There are a number of ways. The first goal is to increase profit, which is the most natural source of working capital. Determine the overall break-even level for your farm, and then produce more income than this level. This is a simple calculation with a straight-forward solution if it can be implemented. Sometimes a farm operator cannot wait for an entire operating cycle to fix a working capital problem. Additional debt may be required in such a case. For example, a long term asset (such as land) could be pledged for security to create a long term debt (like a 20 year mortgage), with the proceeds placed into your bank account to support operations. Other options include selling assets that are no longer required such as machinery and generating cash from other sources such as off-farm employment.
Fixing negative working capital with debt has more recently been viewed by lending institutions as a negative solution. The obvious “catch 22” with this option is that: Banks do not like to lend money to clients who have negative working capital or a problem with their farm’s financial position, even when the purpose is to fix negative working capital. In fairness to the banks, this type of request usually comes after a few years of decreasing feasibility of the farm operation. Though most banks generally try to help farm operators with their financial position, in some cases it may simply be too late.
Though not impossible, farming your way out of a poor cash position is very difficult. First order of importance is determining why your cash position is deficient. For example, if the farm operation is consistently not reaching break-even levels due to poor production practices, the operator should consider exiting the industry. If break-even levels are not reached due primarily to weather related factors, then perhaps the cash position will naturally improve with some co-operation from Mother Nature. Even if weather is a problem, management practices should still be assessed. Excessive moisture in one year may be an anomaly but if it has been wet for five years an adjustment is likely required. Similarly, a hail disaster is never welcome but it is easy to protect against with insurance. Insurance definitely has a cost but a hail loss is not a good excuse for a lack of cash. The cost of production is another area to examine. What are the operation’s cost to farm per acre?...per cow? Can these costs be reduced? A good start here is to break down the land costs, machinery costs, input costs, and all other costs including any personal withdrawals from the operation. The goal is to determine why the operation is short of cash; this understanding will then help drive the solution.
Another cash myth I would like to dispel stems from the infatuation of using cash flow to explain all farm financial issues. Over the past 20 years, “Cash Flow” has become this pit for all farm financial problems and a safe place to hide issues that may be more related to an operator’s management. If a bill couldn’t be paid or loan payment was not possible, a common refrain by many for these scenarios was that the farm operation had a “Cash Flow” problem. In the farmer’s defence, sometimes cash flow was truly the problem but often times the operation had a profitability or working capital problem. Notwithstanding the reasons, it just became more acceptable to refer to these issues as “Cash Flow” problems.
A true cash flow issue is when an operator has enough grain or calves on hand to cover all obligations but, for whatever reason, is unable to sell them. Obtaining cash for assets that are already available is the issue and is a genuine cash flow problem. For example, anytime a farm operator wants to sell grain and is being blocked for some reason (e.g., rail transportation slow-down), that is a real cash flow issue. In the situation that the farm operation does not have enough grain to sell or calves on hand to cover all obligations, this is not a cash flow problem but rather a profitability problem. Similarly, if the operation produced enough this year to cover expenses, but is carrying losses from previous years, this is also not a cash flow problem but rather a working capital problem. An added complexity which is possible is to have all of these problems at the same time.
All farms will at some point encounter cash issues. I once heard that the number one reason for business failure is a lack of working capital. I do not know if that is true but I do think it is possible. Another wise client once told me, “in times of crisis, cash is king”. This I know is true. A great net worth or a long history of profitability is not as helpful as a mitt full of cash in the event of a crisis.
In summary, don’t take cash for granted and try to make the best use of cash at all times possible. If an operation is short on cash, this is most likely a symptom of bigger and systemic problems that need to be addressed. In the case that your operation has residual cash at the end of the year, I would suggest taking a look at the whole operation, with a focus on whether or not there is a real need to purchase equipment or land at this time. After such consideration, you just might reach the conclusion that maybe the best place for that cash is right in your bank account.