Negative Working Capital

 &

Playing on Creditor's Money

The benefits and repercussions associated with the concept of negative working capital(NWC) are usually discussed among students and financial analysts. Before I proceed to initiate this discussion, here's a brief description: 

               Mathematically,

                                         NWC = Current Assets- Current Liabilities  

   

Current Assets include Cash, Raw materials or inventories, account receivables OR in other words, assets which are highly liquid in nature, From companies to small firms, current assets are needed to finance day to day transactions. For example, when a person starts a business, Capital financed through Equity or Debt is used for investing in Fixed assets and some part of it is kept as Cash/Raw materials.

 This portion of Invested Capital which is highly liquid is what is referred to as current Assets.

Current Liabilities, on the other hand, is what you need to pay to the creditors within a stipulated period of time(generally less 1 year). The difference between these is called Net working Capital. 

Based on current Assets and current liabilities,we calculate current ratio to measure the liquidity of a company.

 CR is Calculated as Current Assets/Current Liabilities. 

When we were being vivaed for CBSE XII Boards,most common questions that we were faced with were:  

a. What does a ratio of 4:1 indicate about firm's liquidity position? Is it good? Interpret.(Too much of ideal cash. Utilise it)

b. What is the ideal ratio?( 2:1, again this is what we are expected to answer every time) 

Source: Analysis of Financial Statement by TS Grewal. 

First of all, the answer to a. is rightly stated in the brackets. But answer stated for b.is highly controversial. Ideal Ratio, as I've already discussed, depends on various factors and varies from industry to industry and company to company. It entirely depends on the kind of business the firm is indulged in, whether the business is going concern or not, if the company is Asset Heavy or asset light and others. This will remain the main center of discussion throughout this blog. 

Many students who aspire to be future Analysts (or, at least, what we were taught in school)tend to think that a negative working capital might invite trouble for the company. But negative working capital has become the lifeline for many successful companies like Flipkart, Bharti Airtel and others which rely on the policy of very low or negative working capital. What's wrong with it as long as you are playing on someone else's money? Let's try understanding with a simple example given below :

A person decides to open his new business, say in, grocery. He purchases raw materials from a supplier for $50. Assuming that he's able to sell the material as soon as he buys it,he receives$50 (assuming no margin on sale). Instead of paying the money received,back to the creditor, he invests it in some fixed assets. This is how all items on the credit and debit side get balanced once again. He purchases more material from another supplier for $50 again, sell it to the customers,pays off to the previous creditor. 

What is concluded from the above example?

1.He is earning revenues out of his creditor's pocket.

2. Also, he is creating fixed assets for his company from supplier's money.

3. He is deferring Payment to his suppliers, rolling their dues and utilising it for growing his business for creating Fixed assets for the company.( Assuming that it's a going concern)

The more quickly you convert inventory into cash and higher the credit period, more would be a company's efficiency in utilising negative net working capital. Companies with large customer base and those like FMCGs tend to generate revenues based on their creditor's money.A negative operating working capital is a prerequisite to having an exceptional free cash profile (FCP), a measure of the ability of a company to generate free cash flow as its revenue grows.

                                                         2012                      2013

Current Assets                                 100                      100

Current Liabilities                             120                      150

Net working Capital                          (20)                      (50)

Δ in net working capital = -50-(-20)

                                            =-30

Thus, next time if you notice any company which is operating on negative net working capital in its initial years but observe NWC growing consistenly along with growth in Fixed Assets- know that managers are playing smart.                               

But it does not mean that negative net working capital is ALWAYS good as it's not the case with Asset light companies which do not invest much in Fixed assets.

Also, it may be imperative for a small retailer to have a positive working capital.