Should a company strive for Negative Working Capital or Positive Working Capital?
This is a very common question in interviews in Finance, and in Financial Analysis. And one that confuses many people. Let's try and understand this.
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This is a very common question in interviews in Finance, and in Financial Analysis. And one that confuses many people. Let's try and understand this.
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We know that working capital is calculated as (Current Assets - Current Liabilities). The correct definition should use non-cash Current Assets in the equation. For most companies, this would broadly mean Receivables + Inventory - Payables
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Assume you are running a business - and answer the following 3 questions
- Would you want your customer to pay now or later?
- Would you want high inventory levels or low?
- Would you want to pay your suppliers now or later?
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- Would you want your customer to pay now or later?
- Would you want high inventory levels or low?
- Would you want to pay your suppliers now or later?
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For most - the answers would be NOW, LOW & LATER to the above 3 questions. This would mean low receivables, low inventory, but high payables - thus creating a negative working capital scenario. As a business owner, we want negative working capital.
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Of course there is a tradeoff here while choosing negative WC. Risk vs Profitability. But most businesses would readily take the risk of keeping low current assets as against current liabilities, because in steady state that is the more efficient model.
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You are running the business on someone else's money. It however does not mean that we let payables balloon to a point where it becomes unviable to pay them.
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The confusion over WC arises from the fact that textbooks teach us that Current Assets should cover Current Liabilities, even though some of the very successful businesses run on customer / supplier money, and show negative working capital.
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Also, as WC goes down, this is cash positive for the company, and thus increases the valuation of the company (in DCF). Examples of companies that would be operating with negative working capital - Maruti, Airtel, Bajaj Auto, Eicher, Nestle, some of the cement firms
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If a company which has less receivables can manage the inventory at a level which is lower than payables, negative working capital scenario can be achieved is real. This can be seen in many B2C firms with dominant market share.
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The key to remember however is that the -ve working capital should be by choice, and not by force.
Can you think of any companies that run negative working capital?
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Can you think of any companies that run negative working capital?
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