Rainy Day Fund -- Building Working Capital in Good Times
Farm Management Update, June 1997
By Troy D. Wilson, David M. Kohl, Dixie Watts Reaves, and Amanda J. Wilson of the Department of Agricultural and Applied Economics, Virginia Tech
Agriculture, by nature, is a cyclical industry characterized by volatile commodity prices. Anyone involved in agriculture is aware of this phenomenon and the resulting periods of prosperity followed by challenging times for individual sectors. Increased risk and market volatility will likely result from the Freedom-to-Farm legislation. In order to survive in the long-run, businesses must prepare for the difficult times by saving during the good times. It is essential to build working capital, or liquidity, during profitable periods that will carry the operation through the inevitable periods of break-even returns or losses. Businesses that do not carry sufficient liquidity must either turn to their lenders to finance losses or sell assets to generate cash.
What is Working Capital?
Working capital is defined as the difference between current assets and current liabilities (Working Capital = Current Assets - Current Liabilities). Current assets include cash and near cash items such as savings accounts, marketable securities, inventory, accounts receivable, and other items that could be turned into cash without disrupting normal business operations. Current liabilities include accounts payable, credit card debt, operating lines of credit, accrued expenses, principal due within 12 months on intermediate and long-term debt, and any accrued interest.
The working capital measure by itself is not a useful tool. For example, $30,000 in working capital may be sufficient for a business generating only $100,000 in gross revenues. But $30,000 would be unacceptable for an operation with $500,000 in gross revenues. Financial analysts often compare working capital to operating expenses. A business should have a minimum of 20 percent of farm expenses in working capital. A strong working capital position would have 50% of expenses accounted for by working capital. There should be a trend towards increasing working capital when market prices are strong. For example, with current, strong commodity prices, corn, soybean, and wheat producers should be building working capital.
In any given operating year, a typical business must cover operating expenses, service debt, pay any income tax liability, and provide for family living needs. Any excess earnings that remain can be applied to one or a combination of five main areas: capital replacement and new investments, debt pay down, additional living withdrawals, investing for retirement outside the business, or building working capital. The choice is up to the operator.
Capital replacement is essential to ensure the long-run viability of the operation. A business with depreciating assets must periodically replace these assets in order to maintain productive capacity. A business that depreciates assets without making capital replacements is said to be "living off depreciation." It should be noted that it is not necessary to own the assets, but rather to have control of the assets, as evidenced by the trend towards more leased machinery and equipment. Although capital replacement is important, it is critical to recognize when the business has too many "lazy" capital assets putting an unnecessary strain on the operation. Avoiding "ego purchases" or "killer toys" is a key. New investments in land, buildings, and machinery should be carefully examined and should only be undertaken after a complete financial analysis is performed, comparing current operations to the proposed changes. A producer must also examine the future and determine whether adversity in prices and costs could hinder timely repayment if the new investment is undertaken.
Excess earnings can be used to pay down debt in an attempt to improve the capital position of the operation. Early retirement of debt reduces total interest expense over the life of the loan. The operator must be aware of the possibility of prepayment penalties. The choice to pay down debt should be impacted by other considerations such as the need to replace assets to invest for the future, and to build working capital. The opportunity cost of money must also be evaluated. If loans are locked in at low, fixed interest rates, excess earnings may be more efficiently used in other areas earning a higher rate of return. When considering early retirement of debt, the producer should also consider whether credit will be available during a down turn. A line of credit may not be available in the future if the lender decides to tighten credit standards, making working capital reserves more critical.
An underlying objective in most businesses is to provide a comfortable living for the family. Excess earnings are often used for vacations, family vehicles, and other non-essential items. The key is moderation and balance when looking at family living withdrawals.
Investing for retirement outside the operation is perhaps the most neglected use of excess earnings. Typically, agricultural producers view equity in the farming operation as their source of retirement income. This approach is becoming increasingly risky as people are living longer and outlasting their source of income. Investments in IRAs, SEPs, and other retirement plans should be a serious consideration for the business operator to build liquidity and increase the diversity of wealth in retirement.
The before mentioned uses of excess earnings all reduce the amount available to build working capital in the operation. Working capital accumulation should not be sacrificed. When low commodity prices or bad crop years reduce revenues, it becomes necessary to draw on working capital to meet expenses, service debt, and provide for family living needs. Without working capital reserves, the options are asset liquidation, interim financing, or refinancing short-term debt with long-term notes, all of which may hinder the future success of the operation.
Sources of liquidity are numerous. The most obvious are checking and savings accounts, short-term CDs, and money market accounts. Many lenders, including the Farm Credit System, offer future payment fund accounts which allow borrowers to deposit money in an interest-bearing account that builds reserves for future needs. The reserves can be used to make the next scheduled debt payment or may be withdrawn for emergency purposes. Off-farm employers offering 401(K) or 403(B) retirement plans with a loan provision can also be a source of liquidity. Extra cash can be invested into these plans, and if restrictions allow, a loan can be taken out against the account if the need arises.
The same rules for working capital in a business can be applied to a family household. The general economy is in the 75th month of economic expansion. Families, like businesses, should build liquidity during prosperous times. As a general rule, families should keep two to six months of living expenses in personal liquidity. The risk of injury or unemployment keeping one or more family members out of work for an extended period of time is a serious threat. The number of months of liquidity to keep is dependent on the stability of employment, level of insurance coverage carried, age, and other factors. A single person with few financial commitments could be comfortable with two months of reserve. However, a couple with a mortgage, car payment,and children may want six months of living expenses in cash reserves. The objectives of a short-term savings plan is not to maximize return-on-investment, but to maintain cash liquidity, thus the highest rate of return is not the goal. Credit card lines will not substitute for cash liquidity. These lines can quickly disappear in the case of unemployment or other adverse situation, to say nothing of the high interest rates the credit card companies charge!
Building working capital during good economic times provides flexibility and security to weather periods of low profits or economic recession. Businesses and families should keep a portion of their expenses in near cash assets that can be drawn upon when needed. This cash reserve lessens the business's or family's reliance on lenders and reduces the probability of incurring high interest expenses.
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