Negative Working Capital on the Balance Sheet
Investing Lesson 3 - Analyzing a Balance Sheet
The concept of negative working capital on a company's 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 with the company, 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 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 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, you need to study the DuPont Model return on equity breakdown). Walton 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 to the end of 2017, and you can see that McDonald's had a positive working capital of $2.44 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 was to take advantage of low interest rates and high real estate values and reward McDonald's investors. Specifically, the firm issued a large amount of new bonds, re-franchised many of its corporate-owned stores, and increased 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 more than $155 million as of the end of 2017. 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.
An Example of How Negative Working Capital Might Arise
Examples of negative working capital abound in the retail sector. Let's examine one scenario involving Walmart. Let's say Walmart orders the 500,000 copies of a DVD, and is supposed to pay a movie studio within 30 days. What if by the sixth or seventh day, Walmart has 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, Walmart receives the DVDs, ships them to its stores, and sells them to the customer (making a profit in the process), all before they have 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 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. These businesses don't finance customer purchases and are constantly ringing up a lot of sales. These might include:
- Grocery stores
- Discount retailers
- Online retailers
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 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 1973-1974, though specific industries and sectors do melt down 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.