The difference between liquidity and core equity burn rates
Fall and winter renewal season appears to be setting up to be a tough one. With commodity prices tanking and extreme volatility regarding tariff and trade negotiations, crucial conversations about financial statements will be a high priority between producers and lenders. A producer recently asked me, “What is the difference between financial liquidity and core equity burn rates?”
The financial liquidity burn rate focuses on working capital on the top half of the balance sheet. Working capital is a measure of liquidity calculated using current assets minus current liabilities. Some producers build a working capital buffer through profits. Others have done it by restructuring debt to replenish their working capital. In either case, if your business shows a loss, the financial liquidity burn rate can be calculated by dividing the losses into working capital. For example, if one had $200,000 in working capital and $100,000 in annual losses, the burn rate would be two years. This means that if losses continue at the same rate, the business will deplete its working capital in two years. Profits and cash flow are the business’ first line of defense against losses, and working capital is the business’ second line of defense when losses occur.
The next line of defense is core equity, usually in land assets. In some cases, the majority of equity might be in machinery, equipment, or livestock. This is particularly true if producers are renting and leasing land or strategically controlling assets rather than owning assets.
To calculate core equity, sum the value of non-current assets such as land and buildings. Then, you must determine what loan maximum your lending institution would extend in credit, known as the advance rate. Typically, advance rates will be between 50 and 80 percent. Then, take this number and deduct your liabilities against these assets. The result is called core equity excess reserves. Then, the business owner would divide any losses into this number to ascertain the core equity burn rate in years.
For example, the total value of land and buildings are valued at $1 million. In this case, the lending institution will loan up to 70 percent of the asset value. Therefore, the maximum loan amount would be $700,000. If the producer has $200,000 in liabilities against these assets, the excess core equity would be $500,000. Utilizing the above scenario of $100,000 in annual losses, the core equity burn rate would be five years.
If your business is struggling, this quick analysis will provide an objective look at the options and the element of time in preserving your wealth on the balance sheet.