Negative Working Capital: Good Sign, Red Flag, or Much Ado About Nothing?

Negative Working Capital Definition: Negative Working Capital occurs when a company’s Current Operational Liabilities exceed its Current Operational Assets; it could mean almost anything, depending on the company and industry, and it tends to matter far less in models and valuations than the *Change* in Working Capital.

Initially, many sources claimed that positive Working Capital was “good,” while negative Working Capital was “bad” because it meant that companies could not repay their short-term obligations with their short-term Assets.

This was not accurate because not all short-term obligations needed to be “repaid,” and not all short-term Assets could be readily converted into payments.

Authors and educators then started saying that negative Working Capital could exist for “bad” or “good” reasons, so it was context-dependent:

• GOOD: Negative Working Capital exists because the company collects invoices and cycles through Inventory quickly (low AR and Inventory balances) or because it collects a lot of cash upfront (high Deferred Revenue). The Cash Conversion Cycle is short.
• BAD: Negative Working Capital exists because the company’s sales are falling, leading to lower AR and Inventory, or because it has such poor cash flow it can’t even pay its suppliers on time or at all.

These explanations were better, but there were still two major issues.

First, Working Capital by itself, whether positive or negative, doesn’t matter much for valuation purposes; the Change in Working Capital is far more significant.

Also, even when negative Working Capital means something, that meaning is usually obvious from other metrics, such as the growth rates, margins, and interest coverage ratios.

Files & Resources:

• Negative Working Capital Examples (XL)
• Negative Working Capital – Slides (PDF)
• Walmart – Highlighted 10-K (PDF)
• Dollar Tree – Highlighted 10-K (PDF)
• Salesforce – Highlighted 10-K (PDF)
• Illinois Tool Works – Highlighted 10-K (PDF)
• McDonald’s – Highlighted 10-K (PDF)

Video Table of Contents:

• 0:00: Introduction
• 0:52: The Short Version
• 4:35: Part 1: Dollar Tree vs. Walmart Comparison
• 7:53: Part 2: Positive and Negative Working Capital Examples
• 12:05: Part 3: OK, But Can Negative Working Capital Ever Matter?
• 13:21: Recap and Summary

Defining Working Capital and Explaining Why Negative Working Capital Means Little

When working with this metric, you should use Working Capital as it is defined on the Cash Flow Statement in the “Change in Working Capital” or “Change in Operating Assets and Liabilities” sections, sometimes with modifications.

For example, on Dollar Tree’s financial statements, it does not make sense to include the Operating Lease Liabilities within Working Capital, even though the company lists the Changes in both items in this section:

Leases Assets and Lease Liabilities are Balance Sheet line items, but they are longer-term and relate to multi-year contracts rather than day-to-dash cash collection, payments, and deliveries.

Financing-related items such as Cash, Investments, and Debt should also not be a part of Working Capital, so we are assuming something closer to “Operating Working Capital” here.

Walmart’s Working Capital is more straightforward and follows directly from its Cash Flow Statement.

Our calculations for Dollar Tree and Walmart look like this:

So, Dollar Tree has positive Working Capital, while Walmart has negative Working Capital, and they’re both retailers (though Walmart is far bigger).

Does this mean anything?

No!

First off, they both have mostly positive Changes in Working Capital, and the Change in Working Capital affects Unlevered Free Cash Flow and the valuation from a DCF model.

Second, Walmart has about 35x the revenue of Dollar Tree and more consistent growth rates.

Third, Walmart has higher ROA, ROIC, and ROE metrics, so it is using its capital more efficiently than Dollar Tree to generate after-tax profits.

Also, Dollar Tree is divesting its Family Dollar business, which means its current financial picture is “murky.”

For all these reasons, it’s no surprise that Walmart trades at much higher valuation multiples:

“Working Capital Bros” might look at this and say, “But wait a minute! Walmart is also managing its Working Capital more effectively! The consistent increase in its Accounts Payable, which boosts its cash flows, means it has considerable pricing/negotiating/market power.”

Yes, that’s true, but both companies have mostly positive Change in Working Capital figures:

Also, we can tell just from Walmart’s size that it has considerable market power.

So, the fact that Walmart has negative Working Capital matters little next to everything else and tells us almost nothing new/useful.

More Positive and Negative Working Capital Examples

To illustrate examples in other industries, we’ll look at Salesforce.com [CRM], Illinois Tool Works [ITW], and McDonald’s [MCD].

Salesforce is an enterprise software company and a Software-as-a-Service (SaaS) pioneer, ITW is a manufacturing company with physical products, and McDonald’s is mostly a franchise-based company that collects royalties and owns some of its locations.

(Yes, McDonald’s is a fast-food restaurant chain, but the company itself operates under a franchise model, where individual franchisees pay royalties to the company to operate restaurants under the McDonald’s brand.)

Each one has a different Working Capital and Change in Working Capital, but in all cases, the sign and magnitude of Working Capital matter little.

Let’s start with Salesforce:

Salesforce has negative Working Capital because of its business model: It sells subscription-based software, and it collects significant cash upfront in advance of the delivery and revenue recognition.

As a result, it has a high Deferred Revenue balance, at nearly ~20% of Total Liabilities and Equity, and its Change in Deferred Revenue is consistently positive, boosting its cash flow.

Despite all that, its Change in Working Capital is “mixed” – flipping between barely positive and barely negative – because the increase in Deferred Revenue is not enough to offset the increases in AR, Prepaid Expenses, and Deferred Commissions.

So, the Change in Working Capital will reduce Salesforce’s Free Cash Flow, hurting its valuation in a DCF.

Illinois Tool Works has a positive Working Capital and a mixed-but-mostly negative Change in Working Capital:

The main factor is that its Receivables and Inventory balances far exceed its Payables and Accrued Expenses.

For a manufacturing company with mostly enterprise clients, this is not surprising: They must order the required Inventory in advance, and it takes time to collect cash from customers (large companies usually have more involved payment processes).

But this doesn’t mean that ITW is a “bad” company or that it’s not managing its Working Capital efficiently; it’s just a product of its industry and customer base.

The Change in Working Capital here reduces its Free Cash Flow, but we would expect a negative impact for most companies with physical products.

Finally, McDonald’s often has negative Working Capital as well:

Since it’s mostly a franchise company, it has lower AR and Inventory than a company that directly owns and operates all its locations.

Despite that, the Change in Working Capital on its CFS is negative, meaning that its Working Capital management will reduce its FCF in a DCF-based valuation.

The McDonald’s example encapsulates many of the points above: Yes, there’s a specific reason why its Working Capital is negative, and it tells you something about its business…

…but it’s also pointless because we can tell that it uses a mixed franchise/direct ownership model by reading page 1 of its 10-K or looking at its Income Statement.

The business model’s impact on Working Capital is more of a “side effect” than anything else.

Does Negative Working Capital Ever “Matter?”

People often bring up two specific examples to argue that negative Working Capital matters:

1. Stressed and Distressed Companies – They argue that negative Working Capital can signal big trouble for these types of firms, as it often indicates falling sales, an inability to pay suppliers on time, and cash-flow problems.
2. Small Businesses and Startups – Even if these types of firms are growing rapidly, they could run into trouble if their Working Capital is managed poorly (e.g., if they take too long to collect from customers).

Argument #1 is not that convincing because there are much bigger problems than Working Capital for stressed and distressed companies.

For example, if a distressed retailer cannot pay for an upcoming interest payment or Debt maturity, that is a looming disaster; negative Working Capital just makes it slightly worse.

You often adjust companies’ Working Capital numbers in stressed and distressed scenarios, but it’s far less important than capital structure analysis.

There is more validity to the second claim about startups and small businesses.

Some firms in this category do indeed struggle with their cash flows, and a negative Working Capital can be a leading indicator of this.

Also, it gives you new information that you would not be able to discern from the growth rates, margins, or even the returns-based metrics in this case.

Therefore, if you work with or analyze these types of companies frequently, negative Working Capital could be worth paying attention to, even if it’s not necessarily a “red flag.”