Current ratio: The foundation of farm financial fitness
What a difference time makes. Borrowing costs climbed in 2018 from their historic lows one year earlier. Farm cash receipts flattened nationally over the same period. Over the next weeks, FCC Economics will make sense of these evolving financials and more. Check back weekly to see where Canadian ag is going – and how key financial tools can help you stay ahead of the game.
Canada’s ag sector has been able to sustain a solid financial foundation over the last five years. That will likely be put to the test in 2019, as net cash income will likely flatten this year despite an expected 2% year-over-year gain in revenues. And while I see net worth also growing, both expenses (including interest expenses) and total liabilities will probably increase alongside them.
Liquidity of Canadian farms trends lower, yet remains healthy
Strong working capital is always important, and a year of threatened profitability sharpens the need for it. It’s your first line of defence when expenses grow faster than revenues – which is what I believe we’ll see for several sectors in 2019. This post describes the current ratio, or liquidity, of a subset of Canadian farms* for the 2013-2017 period.
The current ratio measures a business' ability to meet financial obligations as they come due, without disrupting normal operations.
Current ratio = current assets / current liabilities
How it works
There are no hard and fast rules about current ratios, but the financial literature suggests a ratio higher than 1.5 is healthy. If an operation’s current ratio is too high, it may not be using cash as efficiently as possible. A current ratio of 1 to 1.5 indicates a farm is technically liquid, but it could be exposed to financial challenges if market conditions worsen.
A current ratio less than 1.0 means that a farm lacks the current assets to cover short-term liabilities. If working capital is the first line of defence, its absence can force an operation into secondary means of repayment (refinancing of debt) or possibly even selling assets.
The liquidity of Canadian ag operations will likely have been pressured lower in 2018. A year of turbulent markets and rising supply of ag commodities should result in slightly lower revenues for most sectors. At the same time, total farm debt continued to expand in Canada, including short-term debt.
Because of that, I expect current liabilities to have grown at a pace that will have lowered the current ratio in 2018. But I’m confident the strength of Canadian agriculture’s overall working capital will have sustained its health throughout the year.
Figure 1 shows the most recent five-year history of the average current ratio for dairy, hogs, cattle, and grains and oilseeds farms – four of Canada’s largest ag sectors – using FCC’s portfolio data.
Figure 1: Grains and oilseeds sector’s current ratio declined in 2017 – while remaining healthy
Source: FCC portfolio data
These ratios reflect differences arising from each sector’s unique production cycles and volatility in revenues and costs. Although they appear quite different, all four remain well within the range the industry considers healthy.
How an agricultural current ratio evolves
Let’s look at the grains and oilseeds sector as an example. The sector’s current ratio has trended down over the last five years, reaching its lowest point in 2017. Two things stand out to me. The first is that the magnitude of the change is relatively minor. Even at the low end of the five-year period, the ratio is still strong.
The second is that the 2017 ratio reflects specific trends in revenues and expenses. Crop revenues dropped in 2017 for the first time in four years, while the cost of crop inputs climbed. That applied more pressure to grains and oilseeds operations’ working capital.
Figure 1 reports the average ratio by sector. The average is a great benchmarking tool, but individual producers should use it with caution. Some mature grains and oilseeds operations may have a stronger working capital position than other operations that are, for instance, more heavily leveraged during an aggressive expansion phase. The current ratio in both scenarios could be appropriate, each reflecting a healthy operation with different business strategies.
What does the future hold?
Our 2019 Canadian agricultural outlooks forecast increasing revenues and higher input prices, which suggests a flattening net farm income throughout the year. When profitability shrinks, cash, as the saying goes, is king. How producers respond to that trend is the subject of my post next week, when I’ll look at the operating expense ratio.
The current ratio illustrated here is important – but only up to a point. Work with your lender and accountant to determine the suggested ratios for your specific industry and be sure to understand them according to your own strategy and the risks facing your own operation.
Current ratio is important – but only up to a point. Work with your lender and accountant to determine the suggested ratios for your industry. Be sure you consider your own strategy and the risks facing your operation.
* This analysis is based on data from FCC’s portfolio (2013 – 2017).
Are you comfortable using financial statements to better manage your operation? A good place to start is your accountant or an FCC Relationship Manager.
J.P. is the Vice-President and Chief Economist at Farm Credit Canada. Prior to joining FCC in 2010, J.P. was a professor of agricultural economics at North Carolina State University and Laval University. He also held the Canada Research Chair in Agri-Industries and International Trade at Laval. J.P. is Past-President of the Canadian Agricultural Economics Society. He obtained his PhD in economics from Iowa State University in 1999.