Working capital – integration from paddock to profits
PREVIOUSLY, the Farm Financial Series has looked at smoothing out income (through available primary production concessions such as farm management deposits and forced sales) and recently examined small business and the accelerated deductions associated with them.
It seems the logical next step is to now examine how these varying topics impact the operations of the business, from both a revenue and expense perspective.
Working capital refers to the available resources of the business to meet its short-term operational needs.
The formula for calculating the working capital of a business can vary, however the basic agreement is the calculation of current assets less current liabilities as being standard. That is, does the business have enough liquid resources to meet its short term obligations (i.e. within the next 12 months).
This is a crucial aspect of any business, and looking at the primary production industry more specifically it only exemplifies the need for working capital management.
Some operations only sell cattle once a year, so the money received from that transaction needs to be sufficient to support business operations throughout the next 12 months.
That could include obligations such as the associated GST bills from the sale of cattle, any resulting tax bills throughout the year, operating expenses of the business and any improvements.
Cash is a key component of the liquid assets used in working capital. Though a profit and loss statement is an indicator of the financial performance of the business, it may not correlate to a successful tool for understanding the working capital of a business.
This is because a profit and loss gives an historical insight into how the business has performed, and successfully managing working capital requires leading indicators as to provision for the future obligations.
The profit and loss position of a business can also be altered depending on the use of concessions available such as forced sales or accelerated depreciation. If for example a tractor is purchased for $50,000 (GST exclusive) then only part of that amount will be represented on the Profit and Loss as it is not immediately deductable and must be depreciated across the coming years.
However, the cash outlay to purchase that tractor will be $50,000. This example illustrates that the net profit of a business does not directly correlate to disposable cash that can be used to meet future obligations.
As discussed in previous articles, the use of forced sales are a tax deferral and not an offset.
So what does that mean from a working capital perspective? When a forced sale is made, it decreases the taxable income of the business, which results in a decreased tax liability for that year.
From a cash perspective however, the money is received at the point of sale and readily available to be used in the business. This means that the business has more cash than it would have otherwise had given the tax bill has been reduced. In contrary to this, when the forced sale is brought back to account (which must occur across the next five years, depending on what election is made) the subsequent tax bill from that must be paid out of the cash account without any cash injection (as it was received when the forced sale was made).
Understanding working capital allows you to provision for the obligations when they fall due so you can ensure you have the liquid assets to meet these.
Also previously discussed were Farm Management Deposits (FMD), which have an inverse effect on working capital.
Where forced sales defer the tax liability and provides an immediate use of cash, FMDs require the cash to be deposited into a farm management account and must be held there for at least 12 months.
Implementing a tax deferral strategy, using FMDs will be beneficial from a tax perspective but as it takes cash out of the business, it can put a strain on the working capital.
So, what is the best amount of working capital?
So far the article has looked at ensuring there is sufficient working capital and how to manage the varying inflows and outflows that aren’t directly depicted through the profit and loss statement.
However there is also an argument to be made that having too much working capital is a poor business strategy as well.
If there is excess cash than is required to meet the short-term obligations of the business then perhaps that cash is better spent on income producing assets to further increase the cash flow position. There is little benefit to holding cash in the bank for the sake of holding cash. Understanding working capital can allow the decision to be made on whether there is excess cash, and if there is excess cash is it beneficial to invest that as opposed to holding it.
Working capital management is integral in any business, so much so that it was referred to 32 times throughout Woolworths 2018 annual report and was listed as a key performance indicator of the directors.
Though a primary production business varies vastly from the likes of Woolworths or BHP, the premise of working capital management should be integral throughout.
About the Author:
Clancy Cox is a fourth-generation cattle farmer from the Cox and Atkinson lineages. His great-grandfather Monty Atkinson was instrumental in developing the droughtmaster herd which is still incorporated in the family operation today. Clancy was born and raised on “Glensfield Station,” a cattle station 45km west of Mackay. The family operation runs 10,000 head of cattle for breeding and fattening across three properties.
Clancy has a unique understanding of the agribusiness sector, combining his involvement in the family operation with skills he has developed as a Senior Accountant at PVW Partners.
Clancy is passionate about growing regional Australia.
Information provided in the article is of a general nature and is intended for informative purposes only. It does not take into account personal financial circumstances. Tailored professional advice should be sought before acting on any of the information contained above.