What is meant by Zero Working Capital? Example | Approach
The zero working capital approach is a relatively new concept to managing your working capital. It is now gaining importance in working capital management.
What is zero working capital?
A scenario with zero working capital is one in which there is no excess of current assets over current liabilities to be funded. The current assets are equal to current liabilities at all times.
Zero Working Capital (if CA = CL)
To take an example, suppose your current assets and inventories amount to Rs. 5 lacs, and the amount to pay off creditors and meet other bills is also Rs. 5 lacs. In this case, you don’t have an excess of current assets to meet your short-term liabilities. The CA is just equal to the CL. This situation is referred to as zero working capital (i.e., the current ratio is 1).
Companies now strive to maintain their current assets just at the same level as their current liabilities.
The rationale behind this is to reduce the amount of investment required to run a business, which can also thereby raise the return on investment for shareholders. Management normally desires low levels of working capital because working capital earns an exceptionally low rate of return. Therefore, some businesses are currently driving working capital to record low levels, which is referred to as zero working capital.
If firms follow this concept, they try to meet their current liabilities fully out of their current assets. They try to avoid excessive investment in current assets.
As a result, a smooth and uninterrupted working capital cycle is assured, and it would create an environment in which financial managers would constantly strive to improve the quality of current assets in order to maintain 100% realization of current assets.
How to implement this approach?
There are two requirements to implement the zero working capital approach.
1) Demand-based production:
Businesses may adopt a demand-based production model where they do everything only when they are demanded the same. In simple words, production is made in accordance with demand. That is, they fulfill customer orders, procure supplies, manufacture products, and perform similar functions only as and when needed. This ultimately allows businesses to operate on a zero working capital approach.
The production facilities operate 24 hours a day, seven days a week in line with the market demands. There are no inventories; everything is provided on an as-needed basis. As a result of this demand-driven strategy, there is minimal, if any, need for working capital to run the business.
2) Matching Receivable and payable terms:
Another way to implement the zero working capital approach is to streamline receivable and payment terms. The credit granted to customers is curtailed while the payment terms with suppliers are extended. In this situation, ideally, the cash should be received from customers before the payment is due to suppliers. It essentially means that the collections from customers are directly used to fund the payment to suppliers.
Advantages
The most common benefits of having zero working capital can be:
- It may help to raise the overall return on investment for shareholders since it will bring down the total investment required to operate a business.
- The concept of zero working capital requires that the investment in working capital should be as low as possible. If this strategy is followed, it will enable a company to generate timely cash flow while also increasing the company’s production and distribution efficiency.
- Such an approach helps a company to follow a demand-based production system. The production and distribution are done as per market demands as and when needed without having to hold excess inventories.
- Moreover, by keeping working capital at zero, funds can be released for many other opportunities. Instead of tying up funds in working capital, they may be utilized for investment elsewhere, e.g., in high-interest-bearing securities or in long-term assets.
Problems with zero working capital
Implementing a zero WC approach might pose some challenges.
- Because creditors are concerned about receiving their payments timely, they generally desire high levels of working capital.
- Implementing a demand-based production model can be difficult too. Fulfilling customer orders, procuring supplies, manufacturing products, and performing similar functions only as and when needed is not a simple task. It requires a great amount of effort, planning, and coordination of business operations to go on a demand-based production model (also called the Just-in-time approach).
- Also, settling for convenient payment terms with suppliers may not always be possible.
- The goodwill of the organization may get affected if working capital levels are kept at a minimum.
- If a business has zero or negative working capital, it may be possible that it cannot pay its creditors on time. In this case, the company can either go bankrupt or take out a loan with a higher interest rate.
- Firms may find it difficult to obtain loans from outsiders and financial institutions as low working capital levels may indicate that the business is undergoing financial stress when actually this may not be the case.
Conclusion
Zero WC would call for a fine understanding of your business requirements and balancing the finances. Once success is achieved in this endeavour, the results will be reflected in the form of healthier bottom lines.
Companies such as GE (General Electric) and Campbell Soup have made zero working capital a primary strategic goal for the organization. As more and more organizations are finding faster ways to serve their clients, the concept of zero working capital is gaining popularity.
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