Zero Working Capital
Zero working capital is the situation which company has current assets equal to current liabilities. The company does not allocate the capital to invest in the working capital.
Working capital is the different between current assets and current liabilities. It equal to current assets less current liabilities. The current assets include cash, accounts receivable, inventory, advance, and others. And current liabilities include accounts payable, accrued expense, short-term liability, and others. Company usually allocate the capital to the working capital to support the business operation. The current assets are fully funded by the current liabilities, they do not spend their own resource.
Most of the company keeps current assets more than current liabilities which present the liquidation reserve to settle the current obligations. The higher the working capital, the better the company liquidation position. The creditor is highly likely to provide a loan to the company with a higher ratio as it shows that the company in a strong liquidation position.
The company wants to reduce the working capital and use the fund for other investment projects. Management knows that working capital can produce a very low rate of return compared to other investments. If they keep it at a minimum level, there will be many more opportunities to use funds effectively.
The zero working capital is the concept that reduce the company fund and allocate it to other investment. The current assets are supported by current liabilities. However, it can lead to negative working capital which will be another issue.
How to Implement Zero Working Capital
In order to apply zero working capital, company needs to use the following method.
- Demand-base production: inventory is one of the biggest amounts in current assets, so the company will try to minimize it if they want to reduce current assets. We need inventory to sell to customers, but we also try to reduce the amount in the warehouse. Demand-based production is suitable for this situation. We only produce the product when customers place an order, and it will be shipped to customers immediately after that. By doing so, we will be able to decrease the amount of inventory and current assets significantly.
- Receivable management: We need to reduce the receivable balance by collecting them as soon as possible. The company needs to focus on cash sales and strictly allow credit sales. The credit term must be short so that we can collect money early. Moreover, we can request customers to make some deposits during placing an order.
- Payable management: On the other hand, the company needs to look for a longer credit term with the supplier, it will allow us to delay the payment. It will enable us to use the money collected from the customer and pay directly to the supplier.
Zero Working Capital Example
Based on the company financial statement, the current assets and current liabilities list as the following:
|Short term debt
Current Assets = $ 20,000 + $ 50,000 = $ 70,000
Current Liabilities = $ 30,000 + $ 10,000 + $ 30,000 = $ 70,000
Working capital = $ 70,000 – $ 70,000 = 0
It means that the company’s current assets are equal to current liabilities. The company keeps enough current assets to settle the current obligations. They are investing heavily in fixed assets and business operations.
Benefits of Zero Working Capital
- Minimize the investment in working capital: instead of investing in working capital, we can focus on the fixed asset and expand the business operation. It reduces the amount of capital requirement. The company does not require to borrow or raise more funds to support the working capital investment.
- Use more funds effectively: Investment in working capital does not make any profit. Increasing cash on hand, accounts receivable, inventory, and advances will not have an impact on company profit at least in a short term. However, company will lose the opportunity to invest in other areas such as machinery, R&D, and other investment which will increase the profit in both the long-term and short-term.
- Force management to use just-in-time method: With zero working capital, management needs to use funds more carefully and make sure it will not impact the business operation. Just-in-time is the most used method which enables company to achieve the target. For example, the inventory needs to store at a minimum level without causing any impact to customers’ orders. The production will be made only after receiving the order.
Difficulties in Using Zero Working Capital
|Hard to decrease AR amount
|Most customers will not agree to pay early and they even request to extend the credit term. It mostly happens with big customers who have strong purchase power. The company finds it difficult to reject customer requests as it will impact sales quantities.
|Hard to negotiate with the supplier
|The suppliers are also looking to collect their AR as soon as possible. If we want to extend the credit term, they may raise their price which will impact our profitability.
|Not all industries can adopt this system. In a competitive market, customers are going to purchase from suppliers who can provide goods immediately.
|For the service industry, we do not carry inventory but there will be many staff to be paid.