As an investor, you will often come across the notion of negative working capital on a company’s balance sheet. This is particularly true when studying specific industries and sectors. Although the idea may seem unusual, it is something you will encounter frequently. The presence of a negative working capital balance does not necessarily point to an issue inside the organization; in fact, there are circumstances in which this might be seen as a positive. This is how the process goes.
The Meaning of the Phrase “Negative Working Capital”
A corporation is said to have negative working capital when, according to the balance sheet of the company, the amount of its current obligations is more than the amount of its current assets. In other words, the amount of debt with a short-term maturity exceeds the amount of short-term assets.
It is simple to make the assumption that having a negative working capital would result in failure. Taking everything into consideration, if your firm does not have sufficient assets to fulfill its debts, you may be forced to seek the protection of the bankruptcy court since your creditors will begin following you if you do not seek it first. Negative working capital, on the other hand, may be an effective approach to grow a company by attracting the investment of third parties when it is deliberately pursued.
Altering Our Approaches Regarding Working Capital
The amount of negative working capital that a company has may shift over time depending on how the company’s strategy and requirements develop. According to information provided by McDonald’s Corporation, the restaurant chain with the most locations in the world had a negative working capital balance of $698.5 million during the years 1999 and 2000. 1
Moving ahead in time to the end of 2017, you will see that McDonald’s had a tremendous stockpile of cash, which resulted in a positive working capital of $2.43 billion for the company.
This may be attributed, at least in part, to the decision made by the new management to alter the capital structure of the company. The objective was to compensate McDonald’s investors by making use of favorable market conditions, including low interest rates and rising property prices. To be more specific, the company raised cash dividends and share repurchases, as well as increasing the amount of new bonds it issued and franchised a significant number of its corporate-owned shops.
In the meanwhile, a retailer of auto parts known as AutoZone closed out 2017 with a negative working capital of more than $155 million. This happened as a result of AutoZone transitioning to a more effective inventory system, under which it did not really own a significant portion of the merchandise that was stocked on its shelves. Instead, its merchants sent products to the shop for Autozone to sell before asking payment for the goods. This was done before Autozone even opened for business. Because of this, AutoZone was able to free up some of its own money by taking advantage of loans.
The Upside of Having an Unfavorable Working Capital Position
The most common source of negative working capital is when a company is able to swiftly earn cash because it is able to sell things to its customers before it is required to pay the bills that it owes to its suppliers for the initial goods or raw materials. By expanding in this manner, the firm is making good use of the money provided by the vendor.
This was something that Sam Walton, the founder of Walmart, was known for doing. He was successful in generating such a high level of inventory turnover that it pushed his return on equity over the stratosphere (to understand how this works, study the DuPont Model return on equity breakdown).
Walton was a marketing genius, and he would purchase enormous amounts of things, and then he would have a blowout event around it, in order to sell through the products rapidly and utilize the revenues to develop his company.
How a Negative Working Capital Situation Could Develop as an Example
In the retail industry, it’s not uncommon to see examples with negative working capital. Consider the following scenario: Walmart places an order for 500,000 copies of a DVD and agrees to pay the movie studio within the next 30 days. By the sixth or seventh day, Walmart had already placed the DVDs on the shelves of its shops throughout the country, and by the twentieth day, it’s possible that the business had sold all of the DVDs in its inventory.
In this particular scenario, Walmart was the one who got the DVDs, was the one who transported them to its shops, and was the one who sold them to the consumer, all of which occurred prior to the firm having paid the studio. If Walmart is able to maintain this level of cooperation with all of its vendors, the company won’t really have a need to keep sufficient liquid assets on hand to pay all of its accounts payable. This is due to the fact that new cash is constantly being generated at levels that are sufficient to cover any bills that may become payable on any given day. If the transactions are scheduled correctly, the business will be able to pay each bill when it becomes due, which will allow them to operate at maximum efficiency.
Compare the amount of inventory that a company has to the amount of money that it owes to determine whether or not it is operating with a negative working capital balance sheet strategy. This method is fast, but it is not ideal. This is most often the case if the accounts payable balance is very high and the working capital deficit is substantial.
Buying a Company Without Paying Anything
If you are able to purchase a firm for the same amount that it has in working capital, you will have effectively paid nothing for the company. Consider a company by the name of XYZ. The company’s working capital was valued at $933 million at one time in the course of its existence.
After performing the division, it was determined that each share of XYZ stock had a value of $9.16 in working capital. There were a total of 101.9 million outstanding shares. If XYZ’s stock had ever traded for $9.16, you would have been able to buy it “for free” by paying $1 for each $1 that the firm had in net current assets. This would have been the case if the stock had traded at that price. This indicates that you wouldn’t have had to pay anything for the earning capacity of the firm or its fixed assets such as its property, plant, and equipment.
Some businesses did trade at a price that was lower than their net working capital statistics while the stock market was in a bear market in 2008 and 2009. In spite of the failures of some of the assets, wealthy investors emerged from the market who had purchased the securities as part of extensively diversified portfolios. The last time it occurred in any significant way was between 1973 and 1974, while some industries and sectors still continue to suffer on occasion in the same manner as before.
Benjamin Graham, considered by many to be the “father of value investing,” used this strategy to amass a significant portion of his fortune in the years after the Great Depression. Those who are interested in the history of investing will find this fact to be of particular interest. During his stint as a professor at Columbia University, he passed on this tactic to one of his students, Warren Buffett, and instructed him to use it. It was because of this method that Warren Buffett was able to become one of the wealthiest individuals in the history of the world. However, he eventually abandoned this strategy in favor of putting more of his focus on investing in high-quality firms that are purchased and held for the long term.
Those Sectors of the Economy That Typically Have Working Capital Shortages Companies
When dealing with cash-only firms that have good sales and rapid inventory turnover, it is far more probable that you will come across a company with negative working capital on its balance sheet. This is because of the nature of these organizations. These types of companies often do not provide financing for the transactions made by customers and consistently have a large number of sales to those customers. These could include the following:
- Shops that sell groceries
- Retailers offering discounts
- Online retailers
When does having a negative working capital constitute a problem?
Negative working capital is considered to be problematic when it results in actual interruptions to a company’s operations. For instance, if a company often struggles to pay its expenses, this is an indication that the company’s status regarding its working capital is unhealthy. If the company is big enough and has enough customers to constantly turn through its inventory, then it may be able to function without any problems even if it has a negative working capital balance.
How can investors determine the worth of companies that have negative net working capital?
Investors are required to investigate a variety of aspects relating to the business’s operations and finances in order to comprehend what a negative net working capital indicates about the value of a firm. They will need to investigate the turnover rate of inventory and determine whether or not the firm is genuinely having trouble paying its obligations. In essence, the issue that has to be answered is whether or not a negative working capital position is beneficial to the expansion of a corporation or an indication that it has reached a plateau.
What exactly is meant by “net working capital”?
The difference between a company’s current assets and current liabilities is what’s known as its “net working capital,” and it’s used to gauge a company’s financial health. In other words, it shows that it has sufficient liquid assets and the capacity to pay its payments in the immediate future. There are circumstances in which having a negative net working capital is not always a bad thing, despite the fact that a positive figure normally signals short-term financial stability.