SW Financial Literacy
Working Capital vs. Cash Flow (Part 1)
Life is about balance. Too much of anything can be bad.
When it comes to buying real estate. You always need to balance your working capital position vs. your cash flow position.
A farm bought 100% with cash decreases working capital while increasing cash flow.
WC
CF
A farm 100% financed (mostly) maintains working capital while reducing cash flow.
WC
CF
So how do you determine how much cash should be used for a purchase, or when you should focus on preserving your capital and financing more?
Pros of Strong WC
Strong cash positions help you survive the unforeseen expenses.
Working capital (WC) is your short-term risk bearing ability. It protects you from unexpected disasters like the loss of employment, medical expenses, and significant downturns in commodity prices. If you have an above average working capital position, corn going from $7.00/bu to $3.50/bu will in theory hurt a little bit less because you can still operate business as usual.
It helps you sleep soundly at night knowing your business is in safe hands while also providing you with the power to be flexible.
Another benefit to having a strong working capital is it gives you many options for preparing for your next crop. Have cash to prepay for expenses? Great! You won’t be paying interest on a line of credit. There is a discount to prepay for seed, but you want to hold onto grain inventories until your March contract? It doesn’t matter, because your cash position provides you the flexibility to do both.
Cash is king.
The best deals seem to be drawn toward those with cash. Would you rather:
Purchase a $1,000,000 farm on public auction making a $300,000 down payment and finance $700,000?
Purchase the same $1,000,000 farm privately for $800,000, making a $400,000 down payment and financing the remaining $400,000 on seller contract at a lower interest rate with a 5-year balloon.
Option B is obviously the better deal, but many don’t have the extra cash to negotiate this with their landlord before the ground is sent to auction (and yes, I have seen this scenario play out in real life).
With a strong cash position, you have the option to buy and buy again if you maintain strong cash. More cash down allows for stronger cash flows. This snowballs. Having cash gives you more buying and financing options than those without.
Cons of Low WC
When cash is tight, several difficulties arise.
You lose control over how situations are financed. In order to prepay for the next crop, you may be forced to:
Sell your grain (at a low price) to
paydown the line of credit before year end
creating a tax problem.
That’s 3 problems in 1!
When repairs need made and cash isn’t available, you either:
Borrow more on operating (paying more interest)
Term out the repair bill (paying more interest and cutting into cash flow)
Lender says no, so you must go to a high-risk lender or put it on a credit card
With the problems above, there is no time to think about growing the operation as you are in survival mode. That means when your landlord gives you first right of refusal on ground, you respectfully decline. You may not even be able to pick up rental acres since there isn’t enough cash to afford the extra inputs.
When you are illiquid, the once-in-a-lifetime opportunities are missed.
Causes of Low WC
How did you end up in this position? Common causes include:
High family living expenses (vacation every year, leased vehicles, boat & side-by-side)
Giving too much to the next generation (1/2 off rent and paying their home mortgage)
Paying off debt too quickly
Buying land too quickly
Buying new equipment (or trading equipment too frequently)
Bad marketing
Poor debt structure (too much cash down or too short of terms)
Negative cash flow (high input prices, low commodity prices)
How to Fix WC
How do you make an illiquid operation liquid?
Live by a budget (reduce living expenses).
Add income through part-time job or ag side hustle.
Downsize equipment/vehicles or stop replacing them.
Track breakevens by the field (get rid of lease profitable farms) and find ways to improve in every area by 5%.
Work with better professional experts who align with your goals (marketer, CPA, agronomist, equipment dealer, lender).
TRACK YOUR FINANCIALS
Have a WC goal to strive for, with a set date to get there by. Tracked goals work best. Then start taking the baby action steps every day to improve your position. You will overestimate what you can achieve in 1 year but underestimate the impact that can be made in 5 years if you stick to it.
There are a million reasons why you might have a poor cash position, and many are outside of your control (prices). Simplify your situation to control the income, expenses, and decisions you can control.
For a refresher on where your WC levels should be: How to Get Financed Part 3: Capital – Farm640
Come back next week for Part 2 where I address Cash Flow!
Thanks, and have a great day!
Grant
All views expressed on this site are my own and do not represent the opinions of any entity whatsoever with which I have been, am now, or will be affiliated. Information provided is authentic to the best of my knowledge, and as such, is prone to errors and the absence of key details. The content of this blog is for entertainment and informative purposes and should not be seen as professional advice to finances or any other field.