The Dairy Excel 15 Measures of Dairy Farm Competitiveness bulletin was published by Ohio State University extension to provide dairy farmers the ability to evaluate business competitiveness using financial and production information. Measure Eight, Liquidity, as measured by Current Ratio and Working Capital, is discussed in this article.
Competitive Level: Current ratio (CR) = 3.0 to 3.5
Working capital (WC) = ≥ 25% of Gross Revenue
Liquidity
Liquidity is a measure of the farm business’ ability to pay obligations due in the coming year from the cash on hand and assets that can easily be turned into cash. Liquidity is often measured using the current ratio.
This ratio is an indicator of the ability of the current farm assets, if liquidated, to cover current liabilities. A current ratio of 1.5 indicates that there is $1.50 worth of current assets for every dollar of current liabilities. The higher the ratio, the greater the liquidity. The ratio is also an important indicator of short-term financial viability.
Working capital
Another measure of the farm’s liquidity is working capital. Working capital is the difference between the value of the farm’s current assets and current liabilities.
Current assets include cash, savings and other assets that can easily be converted to cash during the year (e.g., cash, stocks, bonds, feeder livestock, accounts receivable, prepaid expenses and inventories, such as feed and supplies).
Current liabilities are financial responsibilities that are due within one year of the date of the balance sheet (e.g., accounts payable, operating loans, principal portion of scheduled loan payments, and other accrued expenses).
A farm business must be able to pay its current obligations and have a cushion for unexpected cash shortfalls. Cash shortfalls may occur because of disease outbreaks, lower than expected milk production, lower milk prices, higher input prices or a combination of factors.
A current ratio (CR) above 1.0 indicates that a farm has more current assets than current liabilities. A competitive dairy farm must pay its bills and keep its bank obligations up-to-date. A CR of 2.0 is sometimes indicated as being strong, but with highly volatile milk markets, this is not high enough.
While receiving milk checks on a regular basis helps with cash flow, long term declines in milk price require cash reserves to pay bills as they are due. The top farms have a CR of 3.5, while average farms that often struggle during market recessions have current ratios of only 2.7.
If the current ratio is low
A persistently low current ratio indicates a major cash flow problem. Strategies to improve the farm’s current ratio include the following:
1. Refinance existing debt with longer repayment terms.
2. Sell nonessential intermediate or long-term assets (e.g., machinery and investments), using the proceeds to reduce debt or improve the efficiency of the dairy business.
3. Increase the farm’s revenue or decrease expenses, focusing on profitability.
A low CR may be the result of a lender extending non-mortgage credit on very short terms, for example, when large pieces of equipment, such as large balers, choppers or combines are financed for three years or less. This strategy results in ratios substantially lower than 1.0 for some farmers because large amounts of principal are due each year. Cash flow is typically very tight. This is not problematic as long as the farm is profitable enough to make the payments and the lender continues to extend credit.
Extending non-mortgage credit gives the lender more control over the loan and the farm. These loans usually are reviewed and renewed at least annually. This large “line of credit” causes some farmers problems when they have bad years, and their lenders will not extend additional credit.
Also, other lenders may consider the farm a high risk because of its poor CR. A low CR is usually a minor problem when the farm is profitable and the debt-to-asset ratio is well below 30% (Measure 10).
However, this is not a long-term answer, but rather a short- term fix. With price volatility, it is important to have cash available to cover expenses when prices are below breakeven.
If the current ratio is high. A high CR indicates surplus cash, which needs to be wisely invested to protect the farm from market down turns. Current assets usually generate lower returns than other assets. If your CR is high, consider investing in assets that generate higher returns (yet allow cash to be accessed when needed).
Working capital
Working capital is another way to evaluate the farm’s liquidity and is a measure of the margin of safety in dollars, rather than as a ratio, of the farm’s ability to meet short-term liabilities. The amount of working capital that is adequate is dependent upon the size and scope of the farm business. However, a common recommendation for farms is working capital equal to 25% of gross revenue.
If you are interested in learning more about the FINPACK program, contact your local extension office or visit https://farmprofitability.osu.
