Maintaining working capital has never been more critical than it is today. It’s also never been more difficult for pork producers to maintain an acceptable level of working capital in order to operate their businesses effectively and efficiently. Working capital restraints do force some business decisions to help maintain capital, but those decisions also can undermine longer-term profitability and may have significant impacts on the producer’s success.
Working capital or liquidity is defined as current assets less current liabilities (or the ratio of current assets to current liabilities). As a key measurement of a company’s ability to generate cash to meet short-term obligations, it increasingly serves as a business’ cushion to absorb volatility. Increased volatility in prices and input costs will increase the need to keep more working capital on hand to buffer the rate at which prices change.
As the industry (hopefully) ends the worst down-cycle in history, obtaining or maintaining a revolving credit facility will continue to be difficult for many farms. A key factor that you will need to discuss with your lender is working capital, current ratio or liquidity.
Although many factors will influence the ability to maintain banking relationships or begin new ones, this article will focus on working capital (liquidity) and how market volatility will impact your need for working capital going forward.
Volatility will be the new normal for agriculture in general and pork production in particular. The ability to predict with some degree of certainty that the market-hog price and input costs will be at a level to provide a profitable outcome is becoming less certain. There are several changes in the industry that lead me to that conclusion, including:
Market price risk — As the U.S. pork industry continues to grow its exports as a percentage of its production, so grows the marketplace volatility. While the export markets have been and will continue to be an important component of the U.S. pork industry’s future, including its price future, exports are less predictable month-to-month than domestic demand. February 2010 lean-hog futures, for example, traded at $49.50 per hundredweight during the week ending Aug. 1, 2009, and as high as $71.50 during the week ending Jan. 16, 2010. February hogs’ trading range exceeded $4 eight times in that 26-week period, or 31 percent of the time. Looking at it another way, the live pigs delivered against February futures would have been worth $99 to $143 per head in gross revenue if sold on the futures after they were born.
Input price risk — The primary issue here is the risk of feed ingredient prices and being able to control major production costs. Again, corn demand has increased with the growth in ethanol production, and prices have changed more dramatically than at any time in history. March corn futures traded in a range from under $3.20 to over $4.20 per bushel during the 26 weeks from August to January, as cited in the previous example. Of course, that now seems rather tame, as corn traded in a range of $3.60 to $6.60 for that same time period during 2008/2009.
Attempting to predict prices for this major input is more difficult with volatility in crude-oil prices, U.S. currency index and commodity hedge-fund activity, in addition to weather, planting acreage, feed use, exports and other factors.
Then, of course, there’s the soybean side, and the growing belief is that it will deepen the volatility prospects on pork production inputs even further.
During times of high volatility, you will need to employ a “margin mentality.” Simply purchasing a quantity of corn or soybean meal and hoping that the price you receive for the finished pig will be there to exceed expenses is not only not the answer, it will add to your risk exposure. Utilizing a margin mentality will force you to develop a strategy with a good understanding of ingredient use to produce pigs and the relationship to lean-hog futures.
From a business management standpoint, you need to understand your working capital position as an indicator of how much risk you can afford to take in the marketplace.
Most swine lenders have historically required a current ratio of between 1.25:1 and 1.50:1 for clients running farrow-to-finish operations. That range is most dependent on the type of production system that the borrower operates. For example, if the producer owns all the facilities, and therefore all current maturities of long-term debt are included in the short-term liabilities, a current ratio of 1.25:1 may be just as acceptable as a 1.50:1 current ratio in a scenario where most facilities are leased and therefore excluded from the liquidity calculation.
Due to the issues of increased volatility discussed above, it’s likely that lenders will require higher levels of liquidity in the future or, more likely, a risk-management plan that can be executed consistently to reduce exposure and impacts on the operation. Going forward in this business, success will be much more dependent on risk management.