The current article provides our response related to a query asked by one of the readers about the interpretation of companies with negative working capital.
How to interpret companies with negative working capital?
Hi Dr. Vijay
Negative working capital is usually considered not favourable as the current liabilities being higher than current assets is not a good sign. But, at times, we have also read that negative working capital is good too. For example, if the cash conversion cycle is negative then your inflow of funds are more and faster than the outflow of funds and hence may result in the negative working capital. Is my understanding correct?
How to analyse negative working capital and find which situations are good and which situations are bad?
Thanks for writing to us.
If the negative working capital is on account of liquidity crunch and not on account of higher bargaining power over vendors/suppliers, then there would be other signs of financial stress in the company like burgeoning debt, delay in project execution, debt servicing requirements being more than CFO etc.
However, if an investor finds that the company that has negative working capital i.e. has current liabilities more than current assets and has its financial parameters in control like conversion of profits (PAT) into cash flow from operations (CFO), a positive free cash flow (FCF), low debt to equity, high-interest coverage ratio etc., then an investor may think that probably, the company is able to get a higher credit period from its suppliers. As a result, the company is able to fund its current assets from its trade payables to a large extent.
An in-depth analysis of the company, its annual reports, credit rating reports etc would provide an investor with the required information to assess whether the company is genuinely able to get a higher credit period from its suppliers or it has long-pending payables due to liquidity crunch.
Let us see the case of a company, which seems to be able to get a higher credit period from their suppliers.
Ion Exchange (India) Ltd:
Ion Exchange (India) Ltd is an Indian company involved in water treatment plants, wastewater processing, sewage treatment, packaged drinking water, and seawater desalination etc.
While analysing Ion Exchange (India) Ltd, an investor notices that the company is able to get very generous terms from its suppliers. Over the years, the trade payables of the company have increased from ₹188 cr in FY2010 to ₹415 cr in FY2019. It indicates that the company could use ₹227 cr of money of suppliers in its operations, which is more than the money of Ion Exchange (India) Ltd that got stuck in trade receivables over the last 10 years (FY2010-2019).
The credit rating agency, CRISIL, in its credit rating report of the company in Aug. 2017 has highlighted that Ion Exchange (India) Ltd is able to control its working capital despite high receivables days because it is able to get back-to-back arrangements from its suppliers.
Weaknesses: Working capital-intensive operations: This is reflected in its high gross current assets of 276 days as of March 2017 (217 days as of March 2016). The increase was primarily on account of rise in cash levels owing to receipt of advance from the National Water Supply and Drainage Board, Sri Lanka (NWSDB). Receivables period was at 162 days due to adverse conditions in the client markets, especially in the power and metal industries where the group executes large orders. The group stores minimal inventory of around 43 days. Payables have remained steady, averaging about 220 days over the past few years. The group, to an extent, is protected against working capital issues due to back-to-back arrangements with suppliers.
As a result, when an investor compares the cumulative net profit after tax (cPAT) of the company with the cumulative cash flow from operations (cCFO) for FY2010-19, then she notices that Ion Exchange (India) Ltd has been able to convert its profits into cash flow from operations.
Over FY2010-19, Ion Exchange (India) Ltd has reported a total cumulative net profit after tax (cPAT) of ₹202 cr. whereas during the same period, it reported cumulative cash flow from operations (cCFO) of ₹616 cr. In addition, during this period it did a capital expenditure (capex) of ₹212 cr. As a result, it had a free cash flow of ₹404 cr. (616 – 212).
Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF
While analysing the past annual reports of Ion Exchange (India) Ltd an investor notices that the company has used this FCF of ₹404 cr and incremental debt of ₹51 cr, total ₹455 cr (= 404 + 51) in various manners:
- Payment of interest on the outstanding debt: ₹161 cr of interest expense over FY2010-2019. Please note that the capitalised interest is already factored in the capital expenditure over the last 10 years.
- Payment of dividend to shareholders: ₹37 cr excluding dividend distribution tax.
- Increase in cash & investments: ₹273 cr, an increase in cash & investments from ₹22 cr in FY2010 to ₹295 cr in FY2019 (272 = 295 – 22)
However, an investor would note that despite the presence of significant cash & investment balances, the company is not able to repay its debt completely to become debt-free. This is because of two reasons:
- The cash balance also contains the money received from National Water Supply and Drainage Board, Sri Lanka (NWSDB) as advance, which the company has kept in a dedicated escrow account. This money can be used only for expenses of the Sri Lanka project and not for any other purpose.
- In addition, the company has to give a lot of bank guarantees to other counterparties in the normal course of business like bidding for projects, tenders etc, which are secured by the cash deposited by the company with the banks. These deposits, even though visible in the cash & investment balance, can not be used for any other purpose till the time the bank guarantee issued by the respective bank is outstanding. As per the FY2019 annual report, page 146, about ₹158 cr of deposits are blocked as security for guarantees issued by the banks.
Margin money deposits with a carrying amount of Rs. 15,780.15 Lacs (31st March 2018: Rs. 14,345.19 Lacs) are subject to first charge to secure bank guarantees issued by banks on our behalf.
Nevertheless, the presence of free cash flow indicates that Ion Exchange (India) Ltd has been able to meet all its capital expenditure requirements from its cash flow from operations. As a result, the company could keep its debt level under check over the last 10 years.
Looking at the above publicly-available information, an investor would appreciate that the high payables of Ion Exchange (India) Ltd do not seem to be due to liquidity crunch.
Therefore, whenever an investor comes across a company, which has a high amount of trade payables i.e. high payable days, then she should do an in-depth analysis by reading its annual reports and credit rating reports. She should look at financial parameters like conversion of profits (PAT) into cash flow from operations (CFO), a positive free cash flow (FCF), low debt to equity, high-interest coverage ratio etc.
If the company has these parameters within healthy levels, then the investor may think that probably, the company is able to get a higher credit period from its suppliers. As a result, the company is able to fund its current assets from its trade payables.
Hope it answers your queries.
All the best for your investing journey!
Dr. Vijay Malik
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Registration status with SEBI:
I am registered with SEBI as a research analyst.
Details of financial interest in the Subject Company:
I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.