by: Chris Zoller, Extension Educator, ANR, Tuscarawas County
Liquidity is the ability of a farm business to quickly convert current assets to cash to pay short-term (less than 12 months) cash obligations, debt, family living, and taxes. It is one of several measures used to gauge farm financial performance over time. The United States Department of Agriculture Economic Research Service (USDA-ERS) is forecasting a decline in farm sector liquidity in 2021. This article will discuss working capital, current ratio, and times interest earned ratio financial measures.
Working Capital
Working capital is calculated by subtracting current liabilities from current assets. Let’s assume a farm has $300,000 in current assets and $175,000 in current liabilities. This farm has $25,000 ($300,000 – $175,000) in working capital. There is no standard dollar amount of working capital needed for businesses as it will vary by farm size. Comparing total working capital to gross revenues does provide an indicator of whether a farm’s working capital is “enough”. USDA-ERS forecasts a 13.6% decline in working capital in 2021 from 2020. If realized, this would be the largest decline since 2016.
See the table below to see how your farm compares.
Working Capital to Gross Revenue Ranges
| >30% | Strong |
| 10% to 30% | Caution |
| <10% | Vulnerable |
(Source: University of Minnesota Extension https://extension.umn.edu/farm-finance/ratios-and-measurements)
Current Ratio
The current ratio is sometimes used when discussing liquidity. The current ratio is determined by dividing current assets by current liabilities. Using the example above, this farm has a current ratio of 1.7 ($300,000/$175,000). In this example, for every $1 of current debt (liabilities), there is $1.70 of current assets available to cover it. Using the benchmark chart below, this farm falls into the “caution” category.
Current Ratio Ranges
| Greater than 2.0 | Strong |
| 1.3 to 2.0 | Caution |
| Less than 1.3 | Vulnerable |
(Source: University of Minnesota Extension https://extension.umn.edu/farm-finance/ratios-and-measurements)
Times Interest Earned Ratio
The times interest earned ratio is a less commonly known measure used to gauge the ability to service the interest portion of debt out of net farm income. Typically, interest is a cash expense and the principal portion of debt is paid out of net farm income. The times interest earned ratio is calculated as net farm income, less interest expense, divided by interest expense. A value less than 1 indicates that there is not enough cash coming from farm operations to make interest payments. Without a cash inflow from outside the farm, the ability to make interest payments would require borrowing or selling assets. It also indicates that the farm business is not generating sufficient dollars to make scheduled principal payments. A higher times interest earned ratio indicates greater ease in making interest payments. USDA-ERS forecasts the times interest earned ratio will decrease from 9.2 in 2020 to 8.4 in 2021. Still, the times interest earned ratio is forecasted to remain above 2014-19 levels.
Summary
It is important to remember that examining only one measure can give a skewed, incomplete picture of farm financial performance. An in-depth analysis of income, expenses, assets, liabilities, and cash flow is needed to provide a comprehensive understanding of financial performance.
I encourage you to schedule a meeting with your lender or Extension Educator to review your balance sheet, crunch some numbers, and discuss any questions as you develop a plan. Whole farm analysis through the Ohio Farm Business Analysis program will also generate these critical financial numbers for your farm as well as benchmark reports with industry comparisons. Additional information is available here: https://farmprofitability.osu.edu.
Sources:
Farm Sector Liquidity Forecast to Decline in 2021, United States Department of Agriculture – Economic Research Service, https://www.ers.usda.gov/amber-waves/2021/march/farm-sector-liquidity-forecast-to-decline-in-2021/
Ratios and Measurements in Farm Income, University of Minnesota, https://extension.umn.edu/farm-finance/ratios-and-measurements#liquidity-796060
The Basics of a Farm Balance Sheet, Ohio State University Extension, https://ohioline.osu.edu/factsheet/anr-64