What’s Your Working Capital to Revenue Ratio

There is a saying in business that a company does not go out of business from a lack of net worth, but from a lack of cash.  An important measure of this “business cash” is to determine your working capital divided by your gross revenues.  The higher this number is, the more “business cash” you have.  Working capital is the “blood” that flows through the business to keep it well lubricated and operating properly.  If you run out of this “blood”, then the business will freeze up and die just like a bearing without the right grease.

Working capital is measured by taking all of your operating assets:

1. Cash,
2. Marketable securities owned by the farm that can be converted to cash quickly,
3. Receivables from the sale of crops and livestock,
4. Inventory of crops and livestock.

From this total you subtract your operating liabilities such as:

1. Accounts payable,
2. Accrued liabilities such as interest, wages, taxes, etc.,
3. Operating lines of credit,
4. Current portion of long-term debt.

Most farmers forget to include the current portion of long-term debt which can dramatically distort your net working capital.  For example, lets take a farm with the following operating assets, liabilities and gross revenues:

• Cash                         $25,000
• Receivables                15,000
• Crops                        175,000
• Accounts payable      20,000
• Operating line           50,000
• Accrued costs            10,000
• Total revenues        400,000

Based on the current information, total working capital is equal to assets of $215,000 less liabilities of $80,000 or $135,000.  This number divided by $400,000 of gross revenues equals the working capital divided by gross revenue ratio of 33.75%.

Most financial advisors would suggest that if this ratio is less than 10%, then the business is in trouble, between 10 to 25% is average and over 25% is very good.  In the case of this sample company, the ratio is greater than 25%, which is very good.

However, lets assume that the farm has financed a bunch of equipment and some land on a fairly short term basis.  For the current year, the farm will be paying off $90,000 of principal on these loans.  How does this effect the ratio.  We would take working capital of $135,000 less the $90,000 of debt being paid equals net working capital of $45,000.  This number divided by $400,000 equals 11.25%.  This number is very close to being marginal.  Make sure to include this number in your working capital calculation.

There are several ways to increase this ratio on your farm.  The key ones are:

• Control your family spending.  If you take all of the net income of the farm to live on, then your working capital will usually erode over time due to inflation.
• Watch your cash capital purchases.  If your working capital ratio is too low, you will most likely want to finance any required equipment purchases over a longer period of time to allow you to build up your working capital.
• Don’t finance equipment with your operating line of equipment.  This decreases your working capital and liquidity and you may not be able to refinance the equipment at a later time.
• Try to set aside some investments outside the farm.  Each month if you can, put money into mutual funds, savings or other non-farm assets.  As these items build up, they provide a cushion for harder times later on.