The concept of negative working capital on a company's balance sheet might seem strange, but it's something you run into many times as an investor, especially when analyzing certain sectors and industries. Negative working capital does not necessarily indicate a problem with the company and, in some cases, can actually be a good thing. Here's how it works.
Defining Negative Working Capital
Negative working capital describes a situation where a company's current liabilities exceed its current assets as stated on the firm's balance sheet. In other words, there is more short-term debt than there are short-term assets.
It's easy to assume that negative working capital spells disaster. After all, if your company doesn't have enough assets to cover its bills, you may have to seek the protection of the bankruptcy court because your creditors are going to start pursuing you. When done by design, though, negative working capital can be a way to expand a business by leveraging other peoples' 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 it has to pay the bills to its vendors for the original goods or raw materials. In this way, the company is effectively using the vendor's money to grow.
Sam Walton, the founder of Walmart, was famous for doing this. He was able to generate inventory turnover so high it drove his return on equity through the roof (to understand how this works, study the DuPont Model return on equity breakdown).
Walton was a merchandising genius, and he would order huge quantities of merchandise and then have a blowout event around it, to sell through the items quickly and use the profits to expand his empire.
Changing Working Capital Strategies
A firm's negative working capital might change over time as the strategy and needs of the business change. Financial data from McDonald's Corporation shows that the world's largest restaurant had a 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 a positive working capital of $2.43 billion due to an enormous stockpile of cash. This is due, in part, to 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 large number of new bonds, franchised many of its corporate-owned stores, and increased cash dividends and share repurchases.
Meanwhile, an automobile parts retailer, AutoZone, had negative working capital of more than $155 million at the end of 2017. This was because AutoZone moved to an efficient inventory system whereby it didn't really own much of the inventory on its shelves. Instead, its vendors shipped inventory to the store for Autozone to sell, before requiring payment for the goods. This provided financing, which allowed AutoZone to free up its own capital.
Example: How Negative Working Capital Might Arise
Examples of negative working capital are common in the retail sector. For example, say that 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 the shelves of its stores across the country, and by the 20th day, the company may have sold all of the DVDs.
In this case, Walmart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before the company has paid the studio. If Walmart can continue to do this with all of its suppliers, it doesn't really 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 whatever bills might be due that day. As long as the transactions are timed right, the company can pay each bill as it comes due, maximizing its efficiency.
A quick, though imperfect, way to tell if a business is running a negative working capital balance sheet strategy is to compare its inventory figure with its accounts payable figure. If accounts payable is huge and working capital is negative, that's probably what is happening.
Industries that Typically Have Negative Working Capital Firms
You're much more likely to encounter a company with negative working capital on its balance sheet when dealing with cash-only businesses that enjoy healthy sales with high inventory turnover. These businesses don't typically finance customer purchases and have a constantly high volume of customer sales. These might include:
- Grocery stores
- Discount retailers
- Online retailers
Buying a Company for "Free"
If you can buy a company for the value of its working capital, you're essentially paying nothing for the business. Consider a firm called XYZ. At one point in its history, the firm had $933 million in working capital.
There were 101.9 million shares outstanding, and doing the division shows that each share of XYZ stock had $9.16 worth of working capital. If XYZ's stock had ever traded for $9.16, you would have been able to purchase the stock for "free," paying $1 for each $1 the company had in net current assets. That means you'd have paid nothing for the company's earning power or its fixed assets such as property, plant, and equipment.
During the stock market downturn in 2008 and 2009, some companies did trade below their net working capital figures. Investors who bought them in broadly diversified baskets got rich despite the bankruptcies that occurred among some of the holdings. The last time it happened in any major way was from 1973 to 1974, though specific industries and sectors do continue to struggle from time to time in this same fashion.
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, built much of his wealth in the aftermath of the Great Depression. It was also this strategy, which he 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 he traded the strategy in and placed more of his investing emphasis on high-quality companies that are bought and held forever.