What does negative working capital mean and why is it a good thing?
Before looking at the issue at hand, I think it is worth specifying why it is important for investors to monitor working capital and its efficient use.
For the company to be able to generate cash flow to shareholders through its business it must invest in capacity to produce products and services intended for sale. This can include purchasing inventories, building a new factory, hiring new employees, or investing in R&D projects. The company expects to generate revenue for each invested euro. When a company sells physical products, for example, it needs some sort of inventory to meet demand. Product sales results in accounts receivable for the company and procurement of products for sale results in accounts payable. In other words, business ties up working capital.
Working capital efficiency
Depending on the nature of the business, and hence the business model, working capital efficiency may be a very relevant component when examining the return on invested capital generated by the business, which ultimately determines whether the company creates value through its business. In other words, the company only generates value through its business and only if the return on invested capital (ROIC) is higher than the cost of capital (WACC). If this is not the case, the business will destroy value in the long run.
The same also applies to growth. Growth in itself only generates value if the return on new invested capital (RONIC) exceeds its required return. In the equation for return on invested capital, the denominator invested capital also includes working capital. By optimizing this, the turnover rate of invested capital (revenue/capital invested) will improve, which together with the operating profitability of the business (NOPAT-%, net operating profit after tax) is one of the components of the return on invested capital. It is especially useful to monitor the efficiency of working capital if the business ties up a lot of working capital (e.g. wholesale trade). I recommend you familiarize yourself with the DuPont analysis to learn more about the components of the return on invested capital.
Value creation
History is an indication of the future, but one should always look forward in both business and investing. To simplify and from the viewpoint of future value creation, the investor should focus on how high the return on new invested capital is over time relative to its required cost and, on the other hand, how long the company will be able to maintain a high return on invested capital.
With reference to this, the value creation of the business can to some extent be influenced by optimizing working capital, which can improve the turnover rate of invested capital (revenue/capital invested). Negative working capital is naturally linked to this.
What is working capital?
First, let’s define working capital. Working capital is inventories + accounts receivable - accounts payable - advances received. When working capital is negative, the sum of the calculation will naturally be negative. In other words, the sum of accounts payable and advances received is greater than the sum of accounts receivable and inventories. Whatever the nature of the business, it always ties up capital (tangible, intangible or so-called intellectual capital). It is therefore also important to relate profits to the capital required to achieve them.
Working capital is, in practice, the capital needed for the operational, i.e. daily, business, without which the company’s business would not run. The sign of working capital is essentially influenced by the company's value chain position, the business model of the company and the type of business it runs. For example, to run a business in the manufacturing industry, the company needs some sort of inventory when manufacturing physical products and naturally it also generates accounts receivable and payable. In most cases, technology companies' sales output is intangible, and thus no physical products are tied to inventories. The inventories in the balance sheet of such companies are very different from those in the manufacturing industry.
In simple terms, one could say that when working capital is negative, customers (incl. suppliers) finance the operations. In this case, net capital is not tied to working capital, like inventories. As the business grows, this is reflected positively in the cash flow of the business, but as revenue decreases, the company is forced to finance the negative working capital itself. On the other hand, if working capital is positive, the company finances the business of its customers. Then, capital is tied to working capital as the business grows, which is reflected negatively in the operating cash flow. In this case, if revenue shrinks, the effect is reverse on the operating cash flow. Next, we’ll look at what factors may lead to this.
Positive working capital can be the lifeblood of a company's business model and strategic choices, deviating from which may dramatically change the company's business. For example, in a situation where the company's customer base is highly concentrated, the company depends on certain customers and these customers order large volumes, the customers inevitably have some bargaining power.
In this situation, the company must be able to secure its supply capacity within the framework of contract terms, which means that more capital than usual is tied to inventories and also accounts receivable due to the weak negotiating position. The aim is to secure supply capacity and hence competitiveness. The negotiating position with suppliers and customers, i.e. the industry and value chain position, affects the commitment of working capital. Defining a negotiating position, or rather bargaining power or a lack thereof, requires a deeper understanding of the business. A common example of bargaining power could be that the company is so important to its suppliers based on its order volume that it receives better payment terms, because without these, suppliers could, in the worst-case scenario, face financial difficulties.
Negative working capital can be the result of negotiating power generated by the company’s long history. A company can, for example, use rigorous customer and credit risk management to maintain negative working capital. In other words, the company may only deliver products/services to customers with a higher-than-normal risk profile against full advance payment or with short payment periods. On the other hand, the company can be such a significant customer to its suppliers that it receives good payment terms with long payment times. In this case, accounts payable and advance payments are sufficient to cover the payment periods granted to low credit risk customers and the capital that is committed to the inventories required to run the business. Negative working capital creates certain leeway within the service/production capacity to increase daily operations without additional funding.
If the company's business model is built on a broad range of products, it may need to keep significant inventories to maintain its competitiveness and fulfill its value promise. This is inevitably reflected as high inventory levels and may also be affected by the structure of the industry. This often leads to a large amount of working capital being tied to the business.
On the other hand, if the price of the company's product is small relative to the total cost of the customer's end solution, the solution has a high degree of customization or is mission-critical, the cost of changing suppliers may be high for the customer. In this situation, the company's negotiating power with the customer would be excellent, which in turn would create good conditions for agreeing on optimal payment positions in terms of working capital management.
So the impact of the value chain position on the commitment of working capital can be approached from two directions: relative to customers and relative to suppliers. A desirable situation would be as quick turnover time as possible of accounts receivable and correspondingly as long turnover time as possible of accounts payable (i.e. payment positions). If the company is a price taker in its industry relative to suppliers and/or its share of the supplier's business is marginal, the payment periods and therefore turnover times are likely to be relatively short. A similar dynamic also applies to customers, which in concrete terms means, for example, maintaining some inventory levels, weak bargaining power and as a sum of these, both high turnover time of accounts receivable, committed working capital and diminishing operating cash flow.
