Correction: A previous version of this article listed an incorrect equity to asset ratio equation. We regret the error.
If margins tighten as Ag economists are warning, it’s going to be important to consider the potential impacts on your operation. Making sure that your farm is going to be financially healthy in what could be tougher times may set you up in a good position.
Consider this: There were people who emerged as millionaires from the Great Depression. How? They thought differently than the crowd during a tough time – and their choices, based on that different thinking – landed them in a much better position than the majority. I also think of Warren Buffet’s advice: ‘Be fearful when others are greedy and greedy when others are fearful.’
But first you need to know where your operation stands – starting with what might be the most ‘basic’ metrics for your business. I’ve talked about working capital and equity here before, but this is a good time to dust them off and use them as a lens for a fresh perspective on the current situation in Ag.
The first metric for your financial dashboard is working capital. That’s your current assets minus current liabilities, divided by your gross revenue. Your working capital shows you what’s available to reinvest in your business.
We recommend working capital of at least 40% – while most banks want to see around 15-20%. Why the difference? The bank’s first concern is that you will be able to pay them back. Their next concern is that you are financially healthy in the long-term.
We help our clients shoot for the higher percentage because even if you have a tough year, you’d still be able to continue farming with that larger cushion available. When you’re healthy financially, being able to pay the bank back isn’t a problem.
If you recognize that your working capital isn’t as strong as you’d like as we enter potentially tougher years, then you have the opportunity to make different financial decisions based on that. Giving yourself a cushion could make the difference between going out of business and being able to take advantage of opportunities as they arise.
With tighter margins on the way, your working capital needs to be strong. Otherwise, there’s no room for unanticipated problems – no margin for error. Everything would have to go exactly as planned. You couldn’t afford to mess up at all.
The other metric that you need to be tracking, if you aren’t already, is your equity to asset ratio. This is figured by taking your total equity divided by total assets. It shows who owns more of your operation – you or your bank. We want to see that at about 60% for our clients.
When you’re aware of this metric, you gain more leverage. Healthy equity levels give you more power as you work with your bank, because it’s a better situation for all parties.
Figure these two metrics for your operation if you haven’t already, and track them over time. Knowing where you stand will help you make good decisions and use your leverage to help your operation thrive during what may be a more challenging time.