Managing liquidity: Why you should save for a rainy day
Liquidity means different things to different people. For an employee earning a steady salary, the long-recommended guideline is to have three months’ income saved to provide a measure of protection against unforeseen expenses or job loss.
For farmers operating large and complex businesses, influenced by volatile markets and variable production, liquidity isn’t quite so simple.
“It’s important to have a rainy-day fund, especially the past couple of years when it’s rained a lot,” says Cheryl Archibald, FCC director of credit west. “We have lots of conversations with our clients about the need to maintain strong working capital. The key question is, how well could you handle a big drop in production, market prices or both?”
In agriculture, working capital (expressed through the current ratio) measures how well a farm business can cover its short-term obligations from income expected over the next 12 months. While Canadian agriculture remains in sound financial condition overall, the aggregate current ratio of Canadian farmers has slipped in recent years.
In 2019, the aggregate current ratio was 2.2, the lowest level since 2006’s ratio of 2.11. Overall, a current ratio of 1.5 or higher is a good sign.
Build liquidity when the cycle is strong
Archibald believes current ratio is a useful tool, but it’s possible to read too much into it. “It can be misleading,” she says, “because it’s a snapshot taken at a certain point in time.”
To add context to the current ratio, Archibald invites producers to take a multi-year view of their business. During the seven- to 10-year cycle associated with many farm commodities — beef and pork being examples — high prices lead to higher production. Excess production pushes prices downward, causing producers to produce less. The cycle continues, causing incomes to swing significantly from year to year.
The high point of the cycle … is the time to put some extra cash aside for a rainy day.
“Farmers can manage their business by knowing where they are in the multi-year commodity cycle,” Archibald says, “and what the next few years will likely bring.”
This is Archibald’s trouble with current ratio. If a farmer looks at their current ratio during the cycle’s best years, things look deceptively positive. They might see a green light flashing to buy land or other productive assets. Instead, the high point of the cycle — the year or two when the cycle’s best returns are possible — is the time to put some extra cash aside for a rainy day.
Admittedly, the return on a basic savings account is nothing to write home about. Bonds offer somewhat higher returns and keep the money readily available. The cycle’s high point could also be the time to arrange a flexible on-demand loan, even if you don’t need the money then and there.
Each farm also has what Archibald calls a cash conversion cycle within a single year. That’s the process by which farm production turns into revenue (you can’t spend), and revenue turns into cash (you can spend). A dairy farm having milk picked up regularly has a far different annual cycle than a grain farm that receives the bulk of its income after harvest. Laying this cash conversion cycle on top of the multi-year commodity cycle, a farmer can see when to build liquidity and when to draw on it if needed.
“When farmers are generating strong cash flow, they might think there’s a better return from buying newer equipment or paying down debt, or pre-buying next year’s inputs,” Archibald says. “If you focus on building the fortress during these times, you’ll know you can cover your bills with a bit of buffer just in case. You’re also in a better position to take advantage of opportunities that might come up.”
Broad perspectives
What’s your current ratio right now? As Archibald sees it, Canadian farm producers should take a broader view of liquidity. She recommends working with your accountant or FCC relationship manager to understand where you are currently, how that picture has changed in recent years and how you can manage this trend in the future.
Savings accounts and bonds might not be lucrative or interesting, but keeping your farm running and your bills paid during challenging times will more than make up for it.
Says Archibald: “You build the fortress by understanding your peaks and valleys — in a given year and over the longer-term cycle — and how your cash flow works at different times. It’s about effective management of working capital and the thought process behind it.”
Up to date and accurate financial record keeping is essential for cash flow management. Software packages like FCC AgExpert allow you to track, manage and understand your farm’s cash flow. Visit AgExpert.ca for more information.
Know your ratios right now by using this calculator.
From an AgriSuccess article by Kieran Brett.
Learn how to think about saving and investing differently and why you should diversify how you spend – and protect your cashflow.