Importance of Working Capital - Financial Planning and Administration, Business Economics & Finance Video Lecture | Business Economics & Finance - B Com

mind your farm business on real
agriculture calm is brought to you by
RBC Royal Bank
it's been said a million times cash is
king especially during the lower end of
the cycle in a market that's when you're
either glad you saved up or wish you had
had built up working capital these days
if you talk to a lender cash flow
considerations have become much more
important in farm financial analysis and
so that's what we're focusing on for
this episode of the mind your farm
business series my name is Kelvin hepner
and we're discussing the importance of
working capital how to define it how to
track it and how to improve your working
capital with dr. David Cole agricultural
economist and professor emeritus at
Virginia Tech dr. Cole was actually our
first guest if you go back to episode 1
of mind your farm business and the thing
is as he points out it's not rocket
science but maintaining a healthy
working capital level is absolutely
critical for positioning a business for
success
first of all welcome welcome dr. Poole
and thanks for thanks for taking the
time to join us again oh it's great to
be back and Austin joy working with
y'all we're talking about working
capital on on this week's podcast and I
think you've in the past referred to it
as the the king of of financials why
what why do you use that term absolutely
what's happening is working capital
matter of fact I was kind of contested
yesterday in Kansas by an agricultural
producer who says well why is working
capital so important today you know he
said I've never heard about it well
what's happened is as we're playing in
this very plausible economic environment
where costs and prices are all over the
board it's very imperative that
agricultural producers and agriculture
businesses have a financial shock
absorber and working capital and you
know the definition of working capital
is basically current assets that you can
turn to cash within a year without
disrupting normal operations and one of
the things is people are getting kind of
slap-happy right now because they have a
lot of equity on the balance sheets in
other words equity in Landor you know
other assets out there but what can
really shut a business down is when you
cannot generate enough cash or working
capital by taking current assets and
turning them to revenue in cash to cover
expenses to cover debt service and other
obligations and so this world volatility
in the financial markets along with just
all over overall uncertainty in the in
the marketplace and then uncertainty and
cost places a strong premium on the
concept called working capital in the
past is probably more of a focus on
having that equity but as you say equity
equity doesn't pay the bills yeah no
exactly exactly in the past you know IRA
to say well I keep my debt to asset
ratio under 20% if I got the GERD I
can't get her and I have a producer tell
me that in the past few months but my
comment is we world full of dirt doesn't
pay the bills and and one of the things
is I want people to think about this on
the webcast around the podcast year that
number one profits is your Kingdom
number two
cash is a king and again in the past
we've depended so much on the equity on
the balance sheet but the the current
markets and the way things are going uh
you have to be what we call resilient
and agile and that working capital gives
you that resiliency in other words push
comes to shove you cannot you know come
up with the internal revenue and cash
but then it also gives you agility and I
want to talk about the positive aspect
because if you've got working capital
you have cash sometimes you can be in
the marketplace to buy other people's
assets that you know fifty sixty cents
out I'll just give you the classic
examples happening down here in the
states our use farm machinery is way off
anywhere from twenty to fifty percent
if people would have stored some working
capital possibility of some extra cash
in that working capital they could buy
those assets a you know forty fifty
cents on a dollar so it really gives you
that flexibility and gives you that
resiliency and agility that proactively
positioned to your business so when it
comes to actually figuring out your
status your working capital status can
you take us through the the steps the
numbers that we that we need to look at
sure your lender and again I work very
closely with lenders both sides of the
border they often will look at a current
ratio that's just your current assets
things like cash inventory receivables
prepaid expenses and supplies and then
what you'll do is you'll deduct your
accounts payable your operating lines of
credit
and also any principal obligations and
accrued interest that you have in for
example if you had a million dollars of
current assets $500,000 of current
liabilities of course that ratio would
be two to one and of course lenders
would be very very favorable they see a
two to one ratio when that ratio starts
getting down Oh down into under one
point five to one one point two five to
one they become you know a concern but
they will look at other components of
your business because they like to look
at a balanced scorecard but when that
drops down les121 then that raises some
alarm bells and red flags because what
happens is if you were become in an
adverse situation say you had you know
some crop loss or the you know markets
went south then you don't have that
ability to generate that you know extra
cash without disrupting normal operation
so lenders like to look at the current
ratio however I like to and of course we
have a dairy business and I like to use
one that's more applicable to producers
I like to take that same example where
you would have five hundred thousand
dollars of working capital and divided
it into your farm expenses including
depreciation and one of the things is we
like to see above about 33 percent in
other words 33 percent of your expenses
in that working capital what we're
finding is the top 20% of managers will
generally keep that ratio above 33%
actual average about 40 to 50 percent
the bottom 20% is less than 10% and just
uh you know practicality is basically
says push come to shove I can come up
with a third of my expenses and one of
the things we had a quote at one of the
banker conferences in Kansas yesterday
it said working capital is like rocket
fuel
the problem is now in these adverse
economic times producers are burning
through it much quicker than they
expected so those are two examples one
more lenders speak the other one more
producer speak of working capital and
some of the metrics that we look at
talking about burning through it though
using that rocket fuel analogy should or
how how can a producer track how do they
go about following how quickly working
capital is shrinking for example right
now for grain farmers in in in the US
probably find themselves in that
situation oh yeah and you know we call
it we call it the burn rate and here's
what you do you do your actuals or
projected losses and and we'll say
adverse situations day we had a farm
that had 500,000 working capital and it
looks like that there's going to be a
$200,000 margin loss well you would
divide that margin loss into the working
capital and your burn rate it would take
two and a half years at at those losses
to burn through your working capital a
minimum a minimum you would like to see
is one year and of course kind of a
green light would be about three years
and so again what happens is you have to
kind of look at your situation look at
you know the either actual results or
projected results and then divide those
into your neck net working capital to
obtain your burn rate and it's real
interesting what we're finding is people
are really the losses are browning here
south of the border particularly in the
grain industrial we're experiencing now
in the livestock industry and where they
do not have a marketing and risk
management program or they don't have
crop insurance some of those other
components of a risk management program
to solidify the work capital that are
burning through that working capital
much quicker
so when it comes to improving your
working capital selling land is probably
one of the obvious ones but what do you
recommend for for improving your
position well you know it's really
interesting it's funny you brought that
up
because one of the will to say young
producers yesterday yeah he had a little
bit of an attitude he says well I'll
just go out and sell some land and
that's starting to happen here south of
the border but here's the problem
ideally you build that working capital
during the positive part of the cycle so
that now you put that land on the
marketplace oftentimes everyone else is
putting the land on the marketplace so
what we're starting to see is discounted
land values down here and so yes you can
sell off and some people are doing that
to what we call provide financial
liquidity on the top part of that
balance sheet that's one number two is
you can also take and stretch out some
of your operating losses on to term debt
but I want to say this very clear if a
producer does that takes the you know
operating loans that they can't pay down
and puts it on to term debt then they
have to come back with a written plan
showing how they're going to improve
their situation so that two to three
years later they're not back there
knocking on the lenders door requesting
the same components so those are a
couple of ways that you can add
liquidity to the balance sheet
unfortunately what's happening is we're
starting to see more and more land come
up on the marketplace with fewer buyers
and of course you know what happens
there you're going to have discounted
land bays and so one that you can be
proactive in the positive part of cycle
number two you can sell assets and then
of course number three refinancing but I
want to stress if refinancing is the
option the producer at the letter
has to come back with a plan to show how
you're gonna make adjustments also that
you're just not back knocking at the
door so again it comes back to having
that right balance of liquidity versus
equity going how matter will no matter
where you are in the in the cycle
oh absolutely absolutely and it's tough
it's tough to build working capital in a
positive part of the cycle I often I
call it my profit plan my 60 3010 rule
60 percent of your profits go to you
know grow your business and become more
efficient as you drive costs down but
30% of it needs to be diverted in the
top part of the cycle / - goodness
financial shock absorber now you are
going to get much of a return money in
the bank but your return is when you
don't have to sell assets at 50 cents on
the other your return is you might be
able to buy someone else's assets at 50
cents out and of course 10% goes for
your dividend or your spending and so
having a profit plan it's very very
critical to having a financial and
working cat financial liquidity working
capital plan would there be any
difference in ratios between different
types of operations dairy versus beef
vs. yeah I'm glad you asked that that is
a very very common question and the
answer is kind of yes and no down here
we typically thought that the dairy
farmer down here or the poultry farmer
could have less working capital reserves
but what we're finding is that
marketplace is extremely volatile we've
had some contracts actually go bad over
on the poultry side so I would say if
they're relaxed at all it would be a
modest rate relaxation of the rules and
you know the possibilities of what's
going to happen when your poultry in
your your dairy markets in Canada
working capital will become imperative
if some of those what I would call
global macro changes occur so I would
say across the board working capital is
very important and one thing I just
wanted to stress and it's something that
we use in our dairies and in our career
rate we try to also take 10% of those
current assets current assets not your
total assets and have them cash on hand
or one year of debt payment so that one
of the things is that that cash is
readily available in this volatile
market in case you lost a contract in
case for example our cattle went upside
down in the feedlot
down here or in case you had a margin
call or something like that so it makes
sense to break down your your current
assets into even cash versus versus
other assets absolutely and and what I
like to do typically if it's a grain
farmer or livestock farmer I'll have
quite a little bit you know feeder
cattle or they'll have an inventory and
but the thing is that inventory I often
tell people I'd love to go out throw
stones at Graton bins if I hear your
hollow sound then there's grain on the
balance sheet we got something wrong but
also if I throw a stone and a grain bin
and hear a hollow sound when there's no
marketing and risk management plan that
can be very very comparative of
maintaining your working capital in
other words putting some of the floors
so they have price does drop you don't
lose all your working capital reserve so
you look at each sector you look at your
cash segment you look at your
inventories the prepaid expense that's
interesting that's what we call kind of
not the truest to working capital
because oftentimes we will prepay
expenses to you know reduce our tax
obligation but sometimes that prepaid
expense will not become a revenue for
1218
months because you got to plant the crop
you got a harvest crop off in the crop
is stored so there's a concept called
true working capital the true true
working capital of course is cash but
then depending on your inventories and
your sale dates on inventories you know
your true working capital can vary
throughout the year and then of course
prepaid expense oftentimes is kind of a
lag out there so you could be real
strong on that current ratio or working
capital to expenses but you may have to
wait you know nine months or twelve
months before that becomes revenue which
then can be turn to cash so yes you need
to break each down on your current asset
side and on the current liability side
when is your operating line of credit
going to come due on accounts payable
what are the suppliers going to want
their money also what is your principal
and interest payments when are they due
so having that debt schedule knowing
those obligations over on the other side
and then of course matching it over onto
the current asset side very critical and
that's one of the things we're finding
right now as a number of lenders are
working through customers they are
really breaking that down in segments
tax obligations would probably be
another one when you're turning assets
in or in all orientation to cash
absolutely absolutely and one of the
things that we're finding is all of a
sudden people are going oh my goodness I
didn't realize I had this tax obligation
and oftentimes it'll AG about a year
into it
unfortunately it will lag in the year
that you can least afford it and so we
are starting to see some financial
stress because of the tax obligations
where people deferred income or push
taxes for the future or get hit with a
double barrel with the tax obligations
well what about for young farmers
looking to have a health
the working capital see a young producer
has just bought land and so they're
heavy on on equity how how can they how
can they maintain a healthy working
capital oh yeah here's the problem with
young producer they want to grow that
business but then they want to preserve
some of the working capital on so what I
really feel that sometimes they they
have to be what I call selective growth
and the problem is that never occurs
because all the farms come up for rent
or sale all at one time and so one of
the things if possible and if they're
profitable is to stash a year of debt
payment in cash in the bank and and
again you won't do it overnight you
might work that up over a three or four
year period so what I'm trying to say is
put a little aside each and every year
still grow because you've got to grow
out there but do it disciplined over a
five to seven year period and then if
some that versus he comes then you will
have it to withdrawal from but it's not
easy for a young producer because
they've got the mixed objectives they
want to grow but they don't want to lose
everything and I had a young couple say
you know we worked hard for this first
million dollars for the equity and we
don't want to lose it overnight so they
actually had a plan where they set a
little side each year when they were in
the profitable part of the cycle so that
they could preserve those assets you
know when the intentional downturn has
common and actually in that case the
downturn has come in they're able to
work through it so it's a real you know
a tough situation there for agriculture
young agricultural producers so if you
could sum this up for producers kind of
give a take home how do you recommend a
farm go about implementing these ideas
and these countries okay Mike
beautif armors let's put this like plan
plan plan and I'm just going to call it
my four-point game plan number one make
sure you have your goals in writing
well I calculated one year goals three
to five year goals and that is very
imperative because in this type of
environment I know we're talking about
working capital communicating with your
family communicating with your lender
and having clarity in that it's very
very important second very very
important is to develop a cash flow
whether it's monthly or quarterly or
semi-annually very critical because if
you go through and develop a cash flow
you're talking about your operations
your marketing plan your financial plan
and then by doing that cash flow you
will see where there might be periods of
surplus and deficit where you may have
to draw on that working capital cash
flow is very very critical to looking at
your working capital needs and then of
course have your balance sheet updated
and play close attention to the top half
of that balance sheet current assets and
current liabilities and then very very
critical scheduled appointment with your
lender or your financial advisor and go
over those financials and in a lot of
people fear that because they think the
lender is just going to criticize them
you know a good lender will say hey
you're doing making progress here you
might want to think about this and and
if you can do those four things right
there that will be imperative in
developing building maintaining and
protecting working capital and actually
protecting your business assets and so
that would be my final four components
and and it was really interesting I had
a farm panel in Kansas yesterday we had
a pretty arrogant young primary while he
was probably in his mid-40s he says
Milan
gonna ask me goals he goes he goes okay
look whatever he was very very arrogant
about that and I could tell that young
man had not been through the tough times
that are gonna come at it and uh and
then he says cash flow he says oh I can
make cash flow look like any you know
anything let's put it this way you got
to be true and honest to yourself and
and and you got to come with the right
type of attitude out there and so as I
was preparing for this podcast today
that was fresh in my mind there are some
people out here they'll just poopoo this
they'll say it's not rocket science
I've actually been criticized online
here called the past years that they say
they paid this guy to say this it's not
rocket science it's not about rocket
science it's back to the basics and for
coming into an economic environment
that's not going to crash we're in reset
and those basics are going to be very
very critical but you gotta come with it
with the right attitude it's not only
working with your lender but it'll make
your business better as well I heard a
speaker this week say things that are
easy to do are also easy not to do so
that would probably apply to us yeah oh
absolutely you know whoever that speaker
was in spot-on absolutely correct and
again it's not about rocket science it's
back to the basics and I got to tell you
I'm speaking in this podcast from the
head in the heart because we operate a
multimillion-dollar business of career
business and we do these and it's the
basics and when we have our meeting on
Monday you know we're going to be going
right through looking at our working
calendars there's looking at our you
know projected versus actual cash flows
and and again what's exciting is when it
when it really does work but it also
gives you a sense of relief you kind of
know where you're at in case you have a
you know macro or micro snafu in the
business well thanks again for taking
the time to
to join us surgical yeah and that that
was very good and I'll enjoy being with
you now I'll be up in Canada you know
doing a series here and hopefully I'll
see some of the people in person and
keep up the good work and I hope
everybody is doing well in Canada so
keeping enough cash and current assets
on hand isn't again necessarily rocket
science as dr. Cole says but of course
we like to test the limits and we get
away with something for a while
especially during the good times and
then things get harder and all of a
sudden a business is in trouble as dr.
Cole says working capital is the
financial shock absorber when you hit a
rough patch
thanks again to dr. Cole to RBC
Financial for partnering with us on
another minor farm business series and
thank you for listening
you