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Working capital is current assets minus current liabilities, or the net corpus available with a company to run its operations. It represents the liquid assets available with the company to meet its current obligations.
Working capital, however, realizes nominal rates of return, and as such, firms prefer to keep working capital levels to a minimum, and deploy the cash for more productive uses. Zero working capital is a new working capital management strategy adopted by companies for this exact purpose.
Image Credit: flickr.com/Eric
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Explanation of the Concept
What is Zero Working Capital? In financial terms, zero working capital is the state where the total accounts receivable, accounts payable, and inventory is zero. Inventory + Account Receivables – Accounts Payables = 0.
A company uses its working capital to purchase inventory, sell goods on credit, collects accounts receivable, and then again purchase inventory. The amount of working capital deployed in a cash conversion cycle bases itself as an optimal trade-off between reducing working capital deployed to purchase inventory, and the potential loss of sales owing to reduced inventory levels or higher costs owing to longer periods of deferred payments. Zero working capital tries to minimize the working capital deployed in the cash conversion cycle to the extent possible, and if possible, continuing the process without any working capital at all.
Zero working capital is a working capital strategy that closely relates to the Just-in-Time methodology. Both the concepts place emphasis on stocking minimal or zero inventories to reduce waste and minimize the use of resources.
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How it Works
There are many ways to operate with zero working capital. Some options include:
- Switch over to demand-based functioning, that is undertaking any activity only on demand. Such an organization starts from a different point in the cash conversion cycle. Instead of buying inventory with working capital, it waits for a specific order, and purchases inventory by either collecting advance payments from the client or by deferring payment to the supplier.
- Outsourcing the entire manufacturing process. The outsourced production supplier drop ships the product to the customer allowing the company to do away with maintaining any inventory, or spend money on manufacturing facilities and overheads. The company makes payments to the outsourced manufacturer only when the customer receives the goods and releases payment.
- Financing inventories by suppliers through accounts payables is another feature of using the zero working capital method. Companies stop selling on credit, adopt an aggressive collection policy to collect payments on time, and collect payments in advance, and simultaneously, delays or stretches out payments to suppliers.
- Eliminating accounts payable by centralizing operations to reduce multiple rents and other overheads, leasing assets such as machinery instead of purchasing them and making the lease payment out of the accounts receivable, and striking strategic functional area partnerships with other companies to use their resources such as marketing, to avoid expenditures on relevant heads.
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When is the methodology of a zero working capital process used?
Companies such as Dell, General Electric, and Campbell Soup have implemented zero working capital to improve their financials. The shift of zero working capital becomes easy when the company's products are in high demand, there are few competing products, and when the company commands a demanding position in the supply chain, with suppliers valuing the company's order.
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Zero working capital helps the company attain financial and production economies by freeing up blocked cash permanently and thereby, raising the company’s earnings, and speeding up the production and sales process to reduce lag in cash inflows.
The concept of zero working capital is still in its infancy. As competitive pressure forces companies to make maximum advantage of its resources, more and more companies look into what is zero working capital, and means to attain such a state.
Reference - Accounting Financial & Tax retrived at: http://accounting-financial-tax.com/tag/how-to-run-a-company-with-zero-working-capital-and-fixed-asset/