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Strategies for Protecting Working Capital

two men talking next to a combine

The hot topic for agriculture heading into 2023 and beyond is working capital. Two years of profitability have put producers in a solid financial position. In the territory served by Frontier Farm Credit, many grain operators have hundreds of dollars of working capital per acre. The focus for next year should be on preserving this liquidity for the challenges – and opportunities – that lie ahead.

Most producers remember the difficult transition between 2012 and 2013 to 2016, when high commodity prices fell faster than expenses, reducing working capital and cash flow. A contraction in today’s record-high commodity prices might be inevitable but financial pain isn’t. The strategies below can help producers protect the liquidity they have rebuilt.

Limit Capital Purchases to Needs, Not Wants

Shortages of equipment and vehicles make this easier to achieve. But history shows that some of the poorest capital investment decisions are made in the best economic times. Approach capital investments with the same discipline in good times as you would in tougher times. Understand how investments, capital or otherwise, impact your cost structure.

Pay Off Operating Debt or Higher-Interest Debt on Shorter-Term Loans Only

Most producers should not prepay their low interest, long-term debt. One reason: Financing an opportunity – say, a land purchase or a fixed asset – will cost more today than most fixed-rate debt currently on balance sheets. Using working capital to pay down low-cost debt only to replace it with higher-cost debt has negative long-term financial implications.

Manage Your Term-Debt Payments

Ensure total annual debt payments can be serviced in a lower-margin environment. Recent profits are two to three times higher than average for the industry. If returns dropped 50% or 65%, could you still make your payments? If you can’t cash flow payments, your liquidity will be further drained by compensating for the shortfall.

Maintain a Reasonable Standard of Living

Family living expenses tend to rise in an environment of strong profits and large cash reserves. Factor in today’s inflationary environment, and family living can quickly eat into working capital when profit margins tighten.

So how much liquidity is enough? The rule of thumb is to maintain working capital equal to 25% of gross income. But with both commodity prices and farm expenses at unprecedented highs, it is commonplace for grain producers to maintain working capital of 50%.

This kind of financial strength provides opportunity for growth. Evaluate what an investment would do to your liquidity and your ability to service debt in a more traditional, low-margin environment. If working capital were to remain strong and you could meet your debt obligations, it could be a good time to expand. Your Frontier Farm Credit financial advisor is available to discuss considerations and options.

Working Capital is a measure of liquidity – or more simply, the dollars that remain after adding up cash and liquid assets, including commodity inventories, minus all debt owed in the next 12 months. Operations are viable as long as working capital is positive. If it turns negative, producers have limited options and may have to resort to refinancing term debt or even selling long-term assets to stay in business.

Cash Flow Exercise

It has never been more challenging to accurately project your future income and expenses. Start with current prices and test against multiple scenarios. The range of possible commodity prices and costs will be much wider than in past years.

Once you understand the risks and rewards of income and expense variables, you can look for opportunities to lock in a margin or protect your downside risk. Locking in your expenses without a risk management plan for your income and sales can be disastrous.