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Extension > Agricultural Business Management News > Liquidity is Strength when Profits are Scarce, How Should it be Measured?

Friday, August 28, 2015

Liquidity is Strength when Profits are Scarce, How Should it be Measured?

by Don Nitchie, Extension Educator

Liquidity has certainly become a hot topic that many people are monitoring in Agriculture with more than two years of significantly lower grain prices.  While livestock operations enjoyed strong returns in 2014 many crop only farms experienced negative returns.  Lower prices also impact the value of grain inventories held as current assets on balance sheets.  In some cases, current liabilities may have also increased as operating loans expanded after decreasing over past years of higher grain prices.

In this changing environment, we know that liquidity, or the ability of the farm business to meet its current financial obligations in the coming year is very important.  Strong liquidity also provides a business the ability to withstand short-term shocks and the flexibility to capitalize on opportunities.  But, what is the best measure of liquidity?  Frequently, the current ratio; current assets divided by current liabilities may have been used in the past to measure your liquidity.  Current assets are typically grain and marketable livestock inventories as well as some cash and prepaid inputs.  Current liabilities are typically annual operating loans and annual payments due on machinery, buildings and land loans. A ratio of 2:1 or above is good and 1.3:1 or below is considered weak.

However, while the current ratio is accurate in telling you the relationship on your balance sheet of your current assets to your current liabilities, it does not relate to your income statement and your size of business.  Many financial experts including the Farm Financial Standards Council now argue that the Working Capital to Gross Revenue measure is a much better measure of liquidity.  Working capital is equal to current assets minus current liabilities.  If Working Capital is 30% or more of Annual Gross Revenues, liquidity is considered strong.  If working capital is 10% or less of gross revenues it is considered weak.

As an example, consider a farm where the current assets are $200,000 and Current Liabilities or debt is $100,000.  This would make the current ratio 2:1, fairly strong by conventional wisdom.  The working capital of this farm is $200,000 -  $100,000 = $100,000.   If the annual gross revenue were $300,000, this means that working capital was 33% of gross revenue-strong according to guidelines.  But, if gross revenues were $1,000,000 annually the working capital would only be 10% of gross revenues and the liquidity situation would not be good.  It would be a struggle to meet current obligations.  So relating your liquidity to the size of your operation is important and should be monitored continuously.  Maintaining strong liquidity will help a farming business survive and thrive in challenging times.

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