Working capital and Canadian agriculture: Is cash still king?
Gearing up for another year? FCC Economics wants to pump up your farm financial fitness. Throughout March, we'll be sharing posts to help put your 2017 farm financials into a larger context. We'll also makes sense of key financial tools as you go. Check back weekly to see where Canadian ag is going and how you can stay ahead.
Our previous post gave examples of Canadian producers’ ability to repay debt when interest rates increase or income declines. In this post, I look specifically at working capital. Good working capital is always important, but when there’s a weakening economy or an industry with declining income – as we expect in 2017 – it’s also your first line of defence. This post examines two ratios you can use to help ensure you’ve got that in place: the current ratio, and the working capital to gross revenue ratio.
I expect the overall liquidity of Canadian agriculture to be pressured lower in 2017. Livestock receipts could fall, as could prices for grains and oilseeds. That, combined with the quality issues of the 2016 harvest in Western Canada should result in slightly lower revenues for the sector overall. At the same time, total farm debt continues to expand in Canada, including short-term debt. Because of that, I expect current liabilities to grow at a pace that will lower both the current ratio and the working capital to gross revenue ratio in 2017, but the strength of Canadian agriculture’s overall working capital will sustain its health throughout the year.
Here’s how I came to that conclusion.
Remember the old adage: Cash is king?
Our Canadian agricultural outlook projects flat revenues and slightly higher expenses in 2017, which suggest net farm income will decline slightly throughout the year. When profitability shrinks, cash, as the saying goes, is king. That will be borne out this year, as the strength of Canadian agriculture’s working capital will position it to face the potential declines in farm profitability.
Working capital (liquidity) measures how much capital is available to a business within the short term (usually one fiscal year). A higher working capital position indicates the capacity to cover short-term liabilities and unforeseen negative economic changes.
It’s calculated by subtracting total current liabilities from total current assets.
Liquidity of Canadian farms remains healthy despite trending lower
Overall, Canadian agriculture shows strong liquidity. It deteriorated 5.1% to $24.4 billion in 2015 when current liabilities appreciated more quickly than current assets, but that was after five consecutive years of growth. Despite the decline, working capital remains 33% higher than it was in 2010.
That’s good news – but it’s not the whole story. To determine whether the available working capital is enough, you must also look at what’s owing in the short term to know if there’s enough capital to cover those obligations.
Canadian current liabilities increasing faster than current assets
Historically strong commodity prices and farm revenues helped increase Canadian total farm debt between 2011 and 2015. While much of that increase was in the long-term liabilities used to finance land purchases, current liabilities also increased over that period, averaging 7.0% annual growth.
Farmland values drove increases in Canadian farm asset values overall, but current asset values – cash, savings, accounts receivable, and inventories (inputs and outputs) – also climbed in this same period. They just didn’t climb as quickly as did the current liabilities, with an annual average 6.4% increase. In 2015, that slowed to a 0.3% crawl.
With short-term debt now growing more quickly than current asset values, there’s a risk that the “current ratio” may also weaken.
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 in the range of 1.5 - 3.0 is healthy. If an operation’s current ratio is greater than 3.0, 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 the secondary means of repayment (refinancing of debt) or possibly, the third line – that of selling assets, potentially at discounted values.
These are financial guidelines only. Work with your lender and accountant to determine the suggested ratios for your specific industry.
Despite the recent relatively stronger growth in debt to asset growth, the current ratio of Canadian agriculture is still in good shape. Strong commodity prices pushed the ratio to 2.7 in 2013, the strongest it’s been since 2008. Since 2013, the current ratio has declined, falling to 2.5 in 2015. That’s still a strong liquid position for Canadian agriculture.
Working capital in Canada today: One final test
Figuring out working capital gives a picture of the cash and cash equivalents available to pay short-term debts, but another important test is determining whether that’s enough to weather a downturn in revenues – you need to account for operation size. Comparing working capital to gross revenue provides another benchmark to evaluate liquidities, providing further insights about Canadian agriculture’s capacity to defend against fluctuations in farm revenues.
Working capital to gross revenue ratio
The working capital to gross revenue ratio measures the capital available relative to the farm’s size.
Working capital to gross revenue = (current assets - current liabilities) / gross farm revenue
How it works
- A ratio greater than 25% indicates farms should be able to withstand fluctuations in revenues.
- A ratio of less than 25% may indicate farms have a liquidity problem.
The working capital to gross revenue ratio of Canadian agriculture remains very strong at 41% in 2015 although slightly lower than the peak of 44% in 2013.
3 key takeaways
- Current assets are the first line of defence to protect the financial health of your business.
- Five consecutive years of growth in working capital have resulted in a relatively strong cash position for Canadian agriculture, despite a decline of 5.1% in 2015.
- Accounting for the recent stronger growth of debts relative to the growth in assets, and for the expected decline in revenues throughout 2017, both the current ratio and the working capital to gross revenue ratio should weaken this year. However, their potential deterioration shouldn’t threaten Canadian agriculture’s ability to absorb the expected changes in the operating environment.
Are you comfortable using financial ratios to better manage your operation? A good place to start is your accountant or an FCC Relationship Manager. For more information on understanding financial ratios, check out our 2016-17 Outlook for Farm Assets and Debt report.