A sustainable business needs effective working capital management. It is one of the most challenging aspects of financial management. An efficient working capital management strategy aims to maximize the return on investment and reduce the insolvency risk.
Networking capital is the difference between your current assets & current liabilities. The need for working capital arises due to the time gaps in the operating cycle, from the purchase of raw materials to production, production to sales, and sales to the realization 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.
Your networking capital is negative when your short-term liabilities are greater than your current assets. Negative working capital can indicate 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 people’s money.
Negative working capital arises when a business can sell a product to the customer before paying 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 that runs on a 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 the 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 cause is selling goods at a loss or a high level of bad debts, it is a bad sign, and the business can face insolvency. If the reason is a 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 the 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. It immediately starts requiring annual working capital investment 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.