Zero Working Capital: Definition, Calculation & Benefits

KEY TAKEAWAYS

• The difference between a company’s current assets and current liabilities is known as working capital.
• Zero working capital is when a company has exactly the same amount of current liabilities as it does current assets.
• If current obligations exceed current assets, working capital may be negative.
• A substantial cash payment that reduces current assets or a sizable credit extension in the form of accounts payable might both result in negative working capital.
• When current assets exceed current liabilities, there is positive working capital. On the other hand, there is no working capital when the reverse is true.

What Is Zero Working Capital?

Zero working capital is a state in which a company’s current assets do not exceed its current liabilities. The idea is to reduce the amount of investment needed to run a corporation, which can also boost shareholder return on investment.

This is opposed to working capital which is the difference between current assets and current liabilities. Accounts receivable, inventories, and accounts payable make up the majority of working capital. 

A company’s investment in working capital is typically sizable and may even be greater than its investment in fixed assets.

How Is Zero Working Capital Calculated?

Zero working capital is calculated using the following formula:

What Is the Approach to Zero Working Capital?

A growing company will never have enough money. This is due to the company’s rising working capital requirements. This makes the zero working capital approach a favorable option. In order to follow this approach, a company will need two things:

• Demand-based production
• Receivable and payable terms

With these two elements as the core of their business approach, a company can experience zero working capital. They could potentially even experience a negative working capital. 

What Are the Benefits of Zero Working Capital?

Zero working capital is one of the newest working capital management strategies. Let’s take a look at some of the advantages of zero working capital in a real-world situation:

Investment Levels

The goal of zero working capital is to boost investments in long-term assets by lowering the level of working capital investment. By employing this method, businesses avoid making excessive investments in current assets. And instead opt to settle their current liabilities entirely with the current assets they already have on hand.

Just-in-Time Methodology

Only if the business adopts the Just-in-Time technique will a zero working capital strategy be feasible. It is suggested that you use the demand-based approach for production and distribution. Inventory levels should be very low or none at all. Everything should be produced and supplied as and when the demand for the same arises.

Opportunity Cost Savings

When comparing working capital to long-term investments, the rate of return is quite low. Maintaining zero working capital will also reduce the opportunity cost of money. This is because the business can use the extra money to take advantage of other opportunities. The management would therefore desire zero working capital due to its advantages.

What Are the Difficulties in Using Zero Working Capital?

Zero working capital may at first seem like an appealing prospect. However, the concept is very challenging to implement and accomplish successfully for the following reasons:

Willingness to Pay in Advance

Customers are normally only willing to pay in advance for consumer items. Larger clients could even demand delayed payment in addition to being unwilling to pay upfront.

Credit Terms

Industry-standard credit terms are normally what suppliers provide to their clients. And they will only agree to lengthier payment terms in exchange for a greater price for the goods.

Time and Demand

Customers may find it challenging to accept a just-in-time, demand-based production system. This is especially true for businesses where rivalry is predicated on fast order fulfillment, which necessitates a certain quantity of on-hand inventory.

Inventory Issues

There is no inventory in the services sector, but there are many employees who are frequently paid more quickly than customers are ready to pay. And in the working capital concept, wages effectively replace inventory and must be paid on a regular basis.

Example of Zero Working Capital

Let’s say that Company X has current assets of $40,000 in cash, and $60,000 in accounts receivable. 

The company also has an accounts payable balance of $30,000, accrued expenses of $20,000, and short-term debt of $50,000.

Using the formula stated above, we can measure whether the company has zero working capital:

ZWC = ($40,000 + $60,000) – ($30,000 + $20,000 + $50,000) = 0

Summary

Though achieving zero working capital, a business can eventually improve the management of its current assets and liabilities. 

Although it’s important to note that it is still thought to be a challenging scenario to accomplish in real-world corporate situations. Therefore it may not be achievable for every company.