Zero working capital is a situation in which there is no excess of current assets over current liabilities to be funded. The concept is used to drive down the level of investment required to operate a business, which can also increase the return on investment for shareholders.
Working capital is the net difference between current assets and current liabilities, and is primarily comprised of accounts receivable, inventory, and accounts payable. The amount of working capital that a company must invest is usually considerable, and may even exceed its investment in fixed assets. The amount of working capital will increase as a business increases its credit sales, since accounts receivable will expand. In addition, inventory levels also increase with sales growth, as management elects to keep more inventory in stock to support ongoing sales, usually in the form of additional stock keeping units to meet the needs of customers.
Consequently, a growing business always seems to be short of cash, because its working capital needs are constantly increasing. In this situation, a company may have an interest in operating with zero working capital. Doing so requires the following two items:
- Demand-based production. It is nearly impossible to avoid increases in working capital if management insists on keeping stocks of inventory on hand to meet projected customer needs. To reduce capital requirements, set up a just-in-time production system that only builds units when they are ordered by customers. Doing so eliminates all stocks of finished goods. In addition, install a just-in-time procurement system that only buys raw materials to support the exact amount of demand-based units that must be produced. This approach essentially eliminates the investment in inventory. An alternative approach is to outsource all production, and have the supplier ship goods directly to the company's customers (known as drop shipping).
- Receivable and payable terms. The terms under which credit is granted to customers must be curtailed, while payment terms to suppliers must be extended. Ideally, cash should be received from customers before it is due for payment to suppliers. This essentially means that customer payments are directly funding the payments to suppliers.
For example, a computer manufacturer can insist upon cash in advance credit card payments from its customers, orders component parts from suppliers on credit, assembles them under a just-in-time system, and then pay its suppliers. The result can be not only zero working capital, but even negative working capital.
While the concept of zero working capital may initially appear enticing, it is extremely difficult to implement, for the following reasons:
- Customers are not willing to pay in advance, except for consumer goods. Larger customers will not only be unwilling to pay early, but may even demand delayed payment.
- Suppliers typically offer industry-standard credit terms to their customers, and will only be willing to accept longer payment terms in exchange for higher product prices.
- A just-in-time, demand-based production system can be a difficult concept for customers to accept in those industries where competition is based on immediate order fulfillment (which requires a certain amount of on-hand inventory).
- In a services industry, there is no inventory, but there are plenty of employees, who are typically paid faster than customers are willing to pay. Thus, payroll essentially takes the place of inventory in the working capital concept, and must be paid at frequent intervals.
In short, zero working capital is an interesting concept, but is usually not a practical implementation. Still, if a company can improve upon its working capital in any of the three key areas, it can at least reduce its investment in working capital, which is certainly a worthy goal.