Negative Working Capital on the Balance Sheet

Investing Lesson 3 - Analyzing a Balance Sheet

Negative Working Capital on the Balance Sheet
Some extremely efficient companies, such as Wal-Mart, can have negative working capital because they sell goods on the shelf faster than they pay the vendor for the merchandise. Getty Images

The concept of negative working capital on the balance sheet might seem like a strange one but it's something you are going to encounter as an investor many, many times over your lifetime, especially when analyzing certain sectors and industries.  It does not necessarily indicate a problem or insolvency and can, in some cases, be a good thing.  But I'm getting ahead of myself.  Let's back up and cover the basics.

The Definition of Negative Working Capital

Negative working capital describes a situation when current liabilities exceed current assets.  In other words, there is more short-term debt than there are short-term assets.  

Negative Working Capital Can Be A Good Thing for Certain Types of Businesses

In a lot of cases, people assume negative working capital spells disaster.  After all, if you can't cover your 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 on other people's money.

Specifically, negative working capital most often arises when a business generates cash so quickly that it can sell a product to the customer before it has had to pay its bill to the vendor.  In the meantime, it is effectively using the vendor's money to grow.

 Sam Walton, the founder of Wal-Mart, 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, you need to study the DuPont Model return on equity breakdown). Part of this was the fact the man was a merchandising genius who could whip up excitement around saving money.

 He'd order huge quantities of merchandise and then have a blowout event around it, taking the profit to expand his empire.  

Furthermore, negative working capital might change over time as the strategy and needs of a business change.  When I first wrote this lesson back in 2001 or 2002, I pulled then-recent data from McDonald's Corporation, showing that the world's largest restaurant had a negative working capital of $698.5 million between 1999 and 2000.  Fast forward fifteen years and you see that for the fiscal year ended 2015, McDonald's had a positive working capital of $4.7351 billion due to an enormous pile of cash.  This is due, in part, to new management's decision to change the capital structure of the business.  The goal is to take advantage of the low interest rate and high real estate value environment, rewarding McDonald's investors.  Specifically, the firm issued a large amount of new bonds, is re-franchising many of its corporate-owned stores to reduce asset intensity and improve return on invested capital, and increase cash dividends and share repurchases.

Meanwhile, an automobile parts retailer that I made a lot of money off of early in my life, AutoZone, has negative working capital of $742.579 million.

 This is because AutoZone has gone to an efficient inventory system whereby it doesn't really own much of the inventory on its shelves.  Instead, its vendors are shipping it to the store, financing it in ways that allow AutoZone to free up its own capital.  It also liberated a lot of wealth it had tied up in its real estate portfolio.  Over the past fifteen years, AutoZone used all of those now-unrestricted funds to buy back incomprehensibly large blocks of its own stock.  It's reduced its shares outstanding from 138,935,636 in 1999 to 30,485,243 at the end of its most recent fiscal year in 2015.  As a result, the stock price went from $32.9375 on January 1st, 1999 to $797.02 per share on March 14th, 2016; a breathtaking increase of almost 2,420%.

It shows in the working capital figure.  As I just mentioned, the balance sheet shows negative working capital of $742.579 million for 5,141 stores.

 A decade and a half ago, when the first was much smaller with only 2,717 stores, it shows positive working capital of $224.53 million.  The decision to increase capital efficiency by focusing on a model built upon negative working capital has turned many shareholders into millionaires.  Of course, the strategy is not without its dangers.  If we were to go into a Great Depression, the company may struggle with its now-higher payments compared to what it otherwise would have had to handle, but the business itself tends to do better during times of economic stress because people buy more auto parts to repair their existing vehicles rather than buy something new.

An Example of How Negative Working Capital Might Arise

Think back to our Warner Brothers / Wal-Mart example earlier in this lesson. When Wal-Mart ordered the 500,000 copies of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the country? By the twentieth day, they may have sold all of the DVDs. In the end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they had paid Warner Brothers! If Wal-Mart 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 fresh, 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 their 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.

Negative Working Capital Firms Tend to Congregate Around a Handful of Industries

You are much more likely to encounter a company with negative working capital on its balance sheet when dealing with cash-only businesses that enjoy high turnovers.  That is, they don't finance customer purchases and are constantly ringing up a lot of volume.  These might include:

  • Grocery stores
  • Discount retailers
  • Restaurants
  • Online retailers

You are likely to see others who still have positive working capital but are running negative cash conversion cycles that would have led to negative working capital had it not been management's policy to hoard cash reserves.  This tends to happen in businesses such as mall clothing retailers, where the returns on capital can be very high but economic sensitivity makes prudent management want a buffer in the event of a sudden downturn.

It Is Sometimes Possible To Buy a Company for Free

If you can buy a company for the value of its working capital, you essentially pay nothing for the business. Earlier in this lesson, one of the original examples I gave from the turn of the millennium was a firm called Goodrich.  (In the years since this was written, Goodrich has been acquired by conglomerate United Technologies.)  In those days, the firm had $933 million in working capital. There were 101.9 million shares outstanding, which meant each share of Goodrich stock had $9.16 worth of working capital. If Goodrich'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 2007-2009 collapse, 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 1973-1974, though specific industries and sectors do meltdown from time to time.  

Those of you who are interested in the history of investing will be fascinated 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 that strategy, which he taught 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 gave it up for an emphasis on high quality companies that are bought and held forever.