When negative is positive | Value Research A negative working capital indicates a business that is efficiently managed and generates higher returns

When negative is positive

A negative working capital indicates a business that is efficiently managed and generates higher returns

When negative is positive

Working capital, as the name suggests, is that part of the total capital (equity + debt) that is used to run the daily operations of a company. Specifically, it is the money invested in building inventory and extending credit to customers. It is calculated as
Working capital = Current assets - Short-term investments - Current liabilities

It's normal for business owners to have enough cash/liquidity to repay creditors and for other daily expenses as and when required. But working capital does not earn any return. Thus a business has to earn enough to justify its working capital.

To earn higher returns on capital, business owners must make their working capital work harder or somehow disappear. The equation above suggests that if current liabilities exceed current assets, then the working capital becomes negative. This effectively means that the company is able to maintain cash in hand plus inventory on its suppliers' money, which is free of any interest cost. The end result is that the business owner has to invest less capital of his own and thus he earns higher returns on each unit of sales. Thus a business that has a negative working capital is much more efficiently managed and generates higher returns.

Cash conversion cycle
An easy way to measure and compare working-capital investment across different businesses over time is through the cash conversion cycle (CCC). CCC conveys the total number of days taken by a company to sell the goods and collect cash. The lower the CCC the better it is. It is calculated as
Cash conversion cycle = Inventory days + Receivable days - Payable days

In this equation, inventory days are the number of days a company holds the inventory before selling it. Receivable days are the number of days a company takes to recover cash from debtors. And payable days are the number of days a company takes to repay its creditors.

The table below lists the BSE 500 companies which have a negative working cycle. We have used the following criteria to filter these out.
1. Remove financial and banking companies.
2. Select the companies profitable in the trailing twelve months.
3. Working capital should be less than zero in the last three years.
4. CCC should be negative in the last financial year.
5. There should be positive cash generation from operations.
6. The debt-to-equity ratio should be less than two.
7. The interest coverage ratio should be more than two.

When negative is positive

Sectors with negative working capital
In the table, the following sectors are frequently repeated. Here are the reasons why they have a negative working capital:
FMCG: FMCG companies charge retailers in advance thanks to their market leadership and brand appeal.
Automobile: Auto companies generally deploy 'just in time' inventory. This helps them reduce inventory. Additionally, they generally charge customers advance payments/booking amounts.
Media: Media companies get paid upfront for subscriptions.

Using VRO
You can calculate the working capital of a stock yourself with the help of the data available on VRO.

Open any stock page and then go to the Financials - Annual tab. Now, find out its Net Current Assets and Current Investments. Subtract the latter from the former and you get Working Capital (shown below).

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