In the last article, a series of questions and answers concerning liquidity of farm businesses was discussed. For the most part, producers are building higher levels of working capital measured by the working capital to gross revenue ratio. Levels of working capital varied by farm enterprise and farm size, while very little variation was noticed by age group.
At the end of the article when debt-to-asset level was compared to working capital, a disturbing trend emerged. Those producers with the highest debt-to-asset ratios maintained the least amount of working capital, often less than 20% or even 10% of revenue.
Working capital is most critical for those producers with the highest financial leverage because it acts as a first-line buffer in case of economic or financial adversity, which can impair profits and cash flow position. This is in part because of the ability to refinance, i.e. use equity as a borrowing base, is severely limited in highly leveraged operations.
Drilling down deeper on this issue by utilizing the farm management data sets of the Minnesota farm management education group finds some interesting perspectives when observing other financial metrics. The group of farms with higher than 80% debt-to-asset ratios exhibited an outstanding return on assets of 14.3%. These producers’ term debt and lease coverage ratio was higher than two to one, another strong financial metric. However, with a group average farm debt to asset ratio of 93%, these farms are in a very precarious financial position if the economic super cycle that has lasted over nine years reverses its course. The lack of a financial liquidity buffer will essentially take these businesses down very quickly.
One hypothesis of why this working capital percentage is so low is that these farms are in a high growth mode, reinvesting the profit back into the business instead of building reserves of working capital. This is frequently a reason why growing too fast is the number one reason businesses fail, proven by this data set.
As a side note, analysis of the data set finds that these highly leveraged operations were renting or leasing approximately 80% of their asset base. To lenders reading this column, if cash rents are bid up too high, this can result in margin compression very quickly, which could be detrimental to these businesses.