What Is Negative Working Capital On The Balance Sheet?

What Is Negative Working Capital On The Balance Sheet?

The concept of negative working capital on a company’s balance sheet may seem strange, but it is something you come across many times as an investor, especially when looking at certain sectors and industries. Negative working capital does not necessarily indicate a problem with the company and, in some cases, can be a  positive thing. Is that how it works.

Negative Working Capital Definition

Negative working capital describes a situation where a company’s current liabilities exceed its current assets as stated on the company’s balance sheet. In other words, there is more short-term debt than short-term assets.

It’s easy to assume that negative working capital spells disaster. After all, if your business doesn’t have enough assets to cover your bills, you may need to seek bankruptcy court protection because your creditors will start coming after you. However, when done by design, negative working capital can be a way of expanding a business by leveraging other people’s money.

The positive side of negative working capital

Negative working capital most often arises when a business generates cash very quickly because it can sell products to its customers before having to pay its suppliers for the original goods or raw materials. In this way, the company is effectively using the supplier’s money to grow.

Sam Walton, the founder of Walmart, was famous for doing this. He was able to generate such a high inventory turnover that it caused his return on capital to skyrocket (to understand how this works, he studies the DuPont model’s return on capital breakdown).

Walton was a merchandising genius, ordering large quantities of merchandise and then having a big event around him, to sell the items quickly and use the profits to expand his empire.

Changing working capital strategies

A company’s negative working capital can change over time as business strategy and needs change. Financial data from McDonald’s Corporation shows that the world’s largest restaurant had negative working capital of $698.5 million between 1999 and 2000.

Fast-forward to the end of 2017, and you’ll see that McDonald’s had positive working capital of $2.43 billion due to a huge cash reserve. This is due, in part, to the new management’s decision to change the capital structure of the business. The goal was to take advantage of low-interest rates and high real estate values ​​and reward McDonald’s investors. Specifically, the firm issued a host of new bonds, franchised many of its corporate stores, and increased cash dividends and share buybacks.

Meanwhile, an auto parts retailer, AutoZone, had negative working capital of over $155 million at the end of 2017. This was due to AutoZone moving to an efficient inventory system where it didn’t own much. part of the inventory on their shelves. Instead, its suppliers shipped inventory to the store for Autozone to sell, before requiring payment for the products. This provided financing, allowing AutoZone to free up its capital.

Example: how negative working capital could arise

Examples of negative working capital are common in the retail sector. For example, let’s say Walmart orders 500,000 copies of a DVD and is supposed to pay a movie studio within 30 days. By the sixth or seventh day, Walmart has already put the DVDs on store shelves across the country, and by the 20th, the company may have sold all the DVDs.

In this case, Walmart received the DVDs, shipped them to their stores, and sold them to the customer (earning a profit in the process), all before the company paid the studio. If Walmart can continue to do this with all of its suppliers, it doesn’t need to have enough cash on hand to pay all of its accounts payable because new cash is constantly being generated at levels sufficient to cover the bills that are due. day. As long as the transactions take place at the right time, the company can pay each invoice when it is due, maximizing its efficiency.

A quick, if the imperfect, way to tell if a company has a negative working capital balance strategy is to compare its inventory number to its accounts payable number. If accounts payable are huge and working capital is negative, that’s probably what’s going on.

Industries that normally have negative working capital companies

You are much more likely to find a business with negative working capital on its balance sheet when it comes to cash-only businesses that enjoy healthy sales with high inventory turnover. These companies generally do not finance customer purchases and have consistently high sales volumes. These may include:

  • Grocery stores
  • Discount retailers
  • Restaurants
  • Online retailers

Buy a company “for free”

If you can buy a company for the value of its working capital, you are paying nothing for the business. Consider a company called XYZ. At one point in its history, the company had $933 million in working capital.

There were 101.9 million shares outstanding, and the split shows that each share of XYZ had working capital of $9.16. If XYZ stock had ever traded for $9.16, you would have been able to buy the stock “for free,” paying $1 for every $1 the company had in net current assets. That means you would not have paid anything for the business’s purchasing power or its fixed assets, such as property, plant, and equipment.

During the stock market downturn in 2008 and 2009, some companies traded below their net working capital figures. Investors who bought them in widely diversified baskets got rich despite bankruptcies among some of the properties. The last time it happened in any major way was 1973 to 1974, although specific industries and sectors continue to struggle from time to time in the same way.

Those who study the history of investing will be interested to know that this working capital approach is how Benjamin Graham, the father of value investing, amassed much of his wealth after the Great Depression. It was also this strategy, taught to his student Warren Buffett during his time at Columbia University, that allowed Warren Buffett to become one of the richest men in history before changing strategy and placing more emphasis on strategy. investment in high-quality companies that are bought and kept forever.

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