A sustainable business needs effective working capital management, it is one of the most challenging aspect of financial management. An efficient working capital management strategy aims to maximize the return on investment and to reduce the risk of insolvency.
Net working capital is the difference between your current assets & current liabilities, the need for working capital arises due to the time gaps in operating cycle, from purchase of raw materials to production, production to sales, and sales to realisation of cash.
Working capital management requires caution due to its direct impact on other components. For example, extending the credit period to customers can lead to additional sales. However, the company’s cash position will fall, potentially leading to the need for a bank overdraft. Interest on the overdraft may exceed the profit arising from the additional sales if there is also an increase in bad debts.
When your short-term liabilities are greater than your current assets, your net working capital is negative, a negative working capital can be an indicator of financial distress or insolvency, but there is always an exception to the rule. In a lot of cases, people assume negative working capital spells disaster. After all, if you cant cover your bills, how will you sustain your business? But when done by design, negative working capital can be a way to run your business on other peoples money.
Negative working capital arises when a business can sell a product to the customer before it has to pay its bill to the vendor i.e. collecting cash up-front but paying the vendors later. It is effectively using the vendor’s money to grow.
HUL is one such Indian company which runs on negative working capital model and it is also successful in increasing its revenue year on year. Negative working capital is often encountered in cash-only businesses that enjoy high turnovers, especially retail sector & restaurant business.
So how do you decide if negative working capital is positive or negative for your business? The answer lies in the reason due to which it is going negative. If the reason is selling goods at a loss or high level of bad debts it is a very bad sign and the business can face insolvency. If the reason is competitive advantage, bulk demand for goods or command in credit terms with the suppliers it is a sign of efficient management.
But some industries cannot and should not use negative working capital model at all, this model only works when the business is growing revenues. When the revenues start declining the positive effect of a negative working capital position reverses and it immediately starts needing annual working capital investment during a time when the company can least afford it.
A virtual CFO can guide you to adopt an efficient working capital management model according to your industry to maximize your returns and minimize risk for the smooth & efficient functioning of the business.