For your farm business to be successful, it’s important that you understand how to measure its financial performance. One way to do this is by looking at the farm’s liquidity. Today, we’ll take a look at three different measures of liquidity that can provide valuable insight into your farm’s financial health.
Working capital is the amount of money that your farm has available to fund day-to-day business operations. Its value is determined by subtracting current liabilities from the farm’s current assets. Current assets include cash, accounts receivable, and assets expected to be turned into cash within one year; current liabilities include amounts to be paid out within one year. Generally speaking, working capital should be greater than 20% of gross revenue.
The current ratio measures the ability of your farm business to meet its current obligations. To find the current ratio, divide the farm’s current assets by its current liabilities. The higher the ratio, the better the farm’s liquidity. Aim for a current ratio of at least 1.25 to allow for price changes or production shortfalls during the upcoming year.
Cash Flow Coverage Ratio
The cash flow coverage ratio reflects the ability of your farm’s operating cash flow to meet its obligations. It’s found by dividing the farm’s operating cash flow by the farm’s current liabilities. This is typically determined on a pro forma basis using a projected cash flow budget. As such, its reliability is limited by the accuracy of this projection. Test the sensitivity of this ratio by determining the effects of different yields, prices, and input costs.
If this ratio is less than 1, then the farm is considered “not liquid.” The higher the ratio, the greater the farm’s liquidity. When you apply for a farm loan, lenders prefer ratios of at least 1.1–1.2.
Ensuring accurate budgeting information is essential for proper financial planning. Periodically compare your budget to your actual reports to locate any variances, and adjust your projections accordingly. Also, keep in mind that these liquidity measures don’t measure overall profitability or your farm’s ability to pay debt that comes due more than a year in the future. So, it’s important to look at other measures of financial health as well.
AgriSolutions provides agricultural accounting and financial consulting services for family farmers, helping them to become more effective business managers and keep their farms thriving through future generations. Click below for a free consultation, and we’ll assess your financial operation, listen to your main concerns, and let you know how we believe we can best serve you.