Is negative working capital always a red flag?
What is Working capital?
It is the difference between the current assets and current liabilities. it includes cash, inventory, accounts receivable, etc that a company uses in its day to day operations to generate cash.
What do we infer from working capital?
Working capital generally gives us an idea of the solvency of the company and its financial position to pay off its current obligations. Negative working capital also implies a quick ratio and current ratio of less than 1. A low or negative working capital hints at an insolvent company. In other words, current liabilities like short term debt, accounts payable, employees payable exceed the current assets which include inventory, account receivables, cash, etc.
But there are cases when a low or negative working capital can signify efficient management and a robust business model. this kind of business model is seen mostly in FMCG companies and some retail companies. This negative working capital is due to the following reasons.
- The company delays payment to its creditors owning to good relations, strong credit history, and bargaining power due to the scale of operations and consistent generation of high-quality cash flow.
- It collects money upfront from customers owning to brand loyalty. in such cases, days payable is much greater than days receivable.
- Very efficient inventory management with a high inventory turnover ratio.
- Efficient supply chain management.
If the working capital is low or negative due to the above reasons, it signals strong and scaling business models. These companies have a high level of cash which is deployed in growth. These companies consistently convert their earnings into cash and earnings in a very short time.
Examples of 2 FMCG giants that have employed this business model are HUL and NESTLE. Nestle collects its money from customers in just four days (average collection period), whereas it pays in 52 days to its raw material suppliers. HUL, which had a net negative working capital has been able to maintain its creditor days at 64 as compared to receivable days at 16.
Given below are snippets of the net working capital vs growth of HUL and NESTLE.
Benefits from Business Model
- Helps to minimize the cost of borrowing
- Early realization of money and lower chances of bad debt are the key reasons for higher profitability.
- The company requires less current assets, which reduces the cost of working capital and eventually maximizes earnings for shareholders.
- These also have a very high return on assets and return on equity.
Drawbacks
Negative working capital indicates non-liquidity or less liquidity within the firm which is not favorable at each and every stage of business. This model is only beneficial when a company is growing its revenues. In case the company isn’t managed properly, it can cause the company to default on some of its obligations creating confusion and panic among investors.
Conclusion
Though low or negative working capital indicates poor liquidity and can be harmful during a recession, FMCG companies have proven to be fairly resistant to recessions and economic slowdowns. Thus, if a company exhibits a negative or low working capital, one must check if the days payable is much greater than the days receivable and whether days working capital is low or negative. Chances are that the company is managing its short term funding very efficiently.
Note: Days working capital is the number of days it takes a company to convert its working capital to revenue. Days working capital can be low when the sales of a company are increasing.
