Current ratio is a curious metric in production agriculture. Sometimes it seems like it is the banker’s most important financial ratio; other times, it seems like bankers could not care less. How can that be?
What is current ratio?
Current ratio is the result of current assets divided by current liabilities.
Current assets include:
- Marketable securities
- Accounts receivable
- Other current assets
- Inventories (i.e. raw material—prepaids)
- Work-in-process (growing crop or livestock)
- Finished goods (stored grain or raised livestock)
Current liabilities include:
- Accrued interest
- Current portion of long-term liabilities
- Accounts payable
- Credit card debt
- Taxes payable
- Other current liabilities
- Your operating note
For most, finished goods inventory is the dominant current asset, and the operating note is the dominant current liability. Thus, the current ratio could be written as:
For many farms, the grain in the bin is roughly equivalent to the operating note due. This makes production agriculture a tough business with margins always squeezed toward zero. For most, especially the heavily leveraged, current ratio approaches one (1.00). A banker can comment on current ratio being near 1.00 (by saying, “1.00 is low and 1.50–2.00 is where we would like you to be”), but the banker will still gladly loan to you if your total equity to total assets ratio (E/A) is strong. Some producers have learned that if they simply pay off their operating note, their current ratio somehow fixes itself. Paying off the operating note has a dramatic and positive impact on the current ratio.
Why is current ratio important?
The widely varying importance of current ratio points to something deeper. Current ratio is not the issue, because some producers perennially report a current ratio below 1.00 without any repercussions. The real issue is risk and who holds it. When the banker holds it, you have a problem.
It is important to understand the three types of risk in production agriculture:
- Catastrophic risk (i.e., fire, tornado)
- Production risk (i.e., yield, price)
- Valuation risk (i.e., widespread disruption of the key markets: trade, currency, credit)
Since farming operations are almost universally financed through the credit (not equity) markets, a paradox emerges. When valuation risk increases, banks react by paying more attention to production risk. In other words, the reason that current ratio seems to have differing importance from time to time is that valuation risk is greater from time to time. As debt investors in your business, not equity investors, banks do not own the risk–you do.
Current ratio is important because the bank will not make an operating loan to buy a growing crop when the assets you have backing that loan are revalued lower. It is at that moment that your cash has to buy the seed, chemical, fertilizer, crop insurance and land rent (and feed for livestock producers). The banks are less inclined to loan to you because they see you increasingly as someone who cannot afford the production risk you seek.
What This Means for Your Farm
In times when there are broad, systemic issues in markets, the farm’s ability to collateralize loans changes. Banks never lend such that they are at risk. The farm always holds the production risk, and when valuation risk balloons, the farm should reduce its risk in turn (i.e., consider scaling back).
Do not fall for the current ratio trap. Freeing up your own liquidity so you can continue operations as usual is not smart. By pressuring you on current ratio, the bank is telling you that the market situation is too risky. Unless you are able to pay insurers or speculators to take the risk, you should be looking to reduce your production risk rather than liquidating your fixed assets to appease your bank’s perception of valuation risk.
For those of you with deep pockets, watch for current ratio drama to reenter the news cycle. Then you know that your fellow farmers without deep pockets are either scaling back and freeing up acres or taking on so much risk that many will be insolvent within a season or two. Just circle above and wait for the right time.
When both production risk and valuation risk happen together (meaning there is a revenue crisis at the same time as a credit crisis), even well-run, powerful farms will go out of business due to lack of capital. The only way to survive in that situation is to quickly deleverage.
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