Liquidity is defined as the ability to immediately cover debt obligations with cash or assets on hand. In other words, your ability to pay your bills.
Liquidity is important to any agricultural business, but may be even more critical depending on what you produce, how long it takes you to produce it and how it’s sold or marketed.
Liquidity is often measured by either a “current ratio” or “quick ratio.” The former comprises current assets – including inventory -- compared to current liabilities. The quick ratio takes inventory out of the equation; it’s made up of cash and other assets that can be quickly converted to cash – compared to current liabilities. Lenders are typically more likely to consider the quick ratio as an indication of a business’ ability to meet short-term obligations since inventory is not always able to be quickly converted to cash.
When liquidity is important
Liquidity’s importance in your operation’s overall financial picture depends on a few main factors. First, if an operation is a smaller, low-inventory business and operates primarily on a cash basis, cash flow is likely more regular and frequent. In this case, liquidity is not as important an indication of financial health, since cash availability is more consistent throughout the year.
In a larger, more inventory-heavy operation, liquidity takes on greater significance as an indicator of financial health.
For example, a crop grower who buys inputs in March but doesn’t get paid until that crop is marketed in the fall needs to account for how he or she will pay the bills during the growing season. A nursery operator with considerable working capital tied up in planted trees or shrubs should also watch liquidity closely, considering the time and work that it takes to sell that inventory and turn it into cash.
Factors influencing liquidity
In industry sectors like these, the importance of inventory puts a premium on closely managing liquidity. Without doing so, an otherwise healthy-looking balance sheet can be misleading if the business is going to rely on product inventory to pay operating expenses and debt.
Another factor that can have considerable influence on liquidity is the point at which an operation sits in its overall life cycle. An established, mature operation will likely have fewer capital requirements than a newer one because of the required investments for buildings and machinery and equipment as the business grows.
Regardless of size or what is produced, a downturn in market prices is a time when liquidity takes on greater significance. When crop prices are low, for example, cash flow is more constrained than when prices are stronger.
Another consideration in managing liquidity is having access to lines of credit. Unused lines of credit are not captured in the current or quick ratios but having this borrowing capacity can provide funds to pay ongoing expenses while crops or livestock are being raised or marketed. When drawn, these lines factor in to the current or quick ratio as short-term liabilities. So while lines of credit can provide an important liquidity backstop, it is important to make sure they can be paid back through ongoing, profitable operations.
Liquidity is a key financial variable to watch regardless of the structure of an agricultural business. But, it’s just as important to consider it in the broader context of making sound business decisions. Short-term liquidity may suffer, for example, if a grain sale is delayed in an effort to net a higher seasonal price. In this case, it’s important to be mindful of liquidity, as maintaining strong short-term liquidity must be balanced against longer-term profitability.
If you have questions about liquidity and its role on your operation, contact your local Farm Credit East business consultant or learn more here.