Firms with low working capital can be good investment bets
Among the several factors that investors can consider while picking stocks is the working capital of a company. This is because it can be an important parameter to judge its operational efficiency as it represents the liquidity available to it.

Working capital is calculated by deducting the company's current liabilities from its current assets. A positive working capital means that the company can pay off its short-term liabilities comfortably, while a negative figure obviously means that the company's liabilities are high.

However, since there are several exceptions to this rule, a negative working capital need not always be a bad thing. Let us consider why some companies have huge negative working capital year after year. The answer is simple: because they can.

Typically, large companies have a consistent negative working capital since they have the muscle power and can demand longer credit periods from their fragmented suppliers. They are also able to make sales in cash or collect payments within a few days. Whatever the reason, the companies find it a beneficial position to be in.

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(Posted date - 26 Nov 2012)
To understand this better, consider the analogy of a trader, who buys goods on a credit card that has a cycle of 45 days. If he can sell all his goods and collect the proceeds within a month, he can roll the money till the card payment due date. This means he can invest for the short term and make additional profit on it.

The negative working capital phenomenon not only depends on the size of the company, but also on the kind of business.

As is evident from the table, consumer-centric firms top the list of the BSE-500 companies that have the highest negative working capital. Which sectors should investors consider?
Sectors
Telecom companies lead the pack. It may seem puzzling that a capital-intensive sector like telecom could have negative working capital, but it's not difficult to understand this. Firstly, the sector does not require raw material. Secondly, most of the capital requirements like licence fee, spectrum cost, tower installation cost, etc, are taken care of at the initial stage. Finally, these companies collect money from prepaid customers in advance, and from postpaid customers, without much delay.

Does this mean that the sector is a good investment opportunity now? "With several licences coming up for renewal, the 2G auction failure is good news for telecom companies. Though they are not very expensive at the moment, the growth rate has come down. So investors can expect only about 10% upside from the current level.

Aviation is another industry that has a high negative working capital because airlines collect the money at the time of booking, months before they spend it to transport you. However, aviation isn't a good bet now. "Since the sector is heavily in debt currently, the negative working capital may not be of much relevance. The domestic aviation industry is also plagued by several other problems like over-capacity, high airport charges, high fuel cost, etc.

Some industries are known for generating fast cash and the FMCG sector is the best example for this. Several FMCG companies have a high negative working capital. This may be because their strong brand loyalty helps them maintain a low inventory as well as generate speedy sales. Since these large companies have a high bargaining power, they are also able to extract favourable terms from their suppliers. The products are sold to the customers and the cash generated even before the company pays its suppliers. The additional cash generated can be utilised for other purposes.

Though FMCG majors are fundamentally strong and well-managed companies, retail investors should avoid them for now because most of them are quoting at very high valuations. "Most FMCG stocks are overpriced now. However, if you want to invest for the long term, you can buy shares of ITC. Its original business, cigarettes, will continue to generate cash in the future. The other two businesses, food and hotel, where ITC is has been making investment for some time, should also generate significant cash in future.

Other parameters
The negative working capital can be used as a screening criterion, but it's not the final stock selection tool. What are the other parameters that investors should consider? The most important is the ability to weed out capital guzzlers, especially from sectors that don't offer very high operating margins. "Some capital-intensive businesses may have negative working capital. Investors should look at those where the need for fixed capital is also less," says Tandon.

Along with the negative working capital, investors should also check whether the company can generate free cash flow. This is calculated as operating cash flow minus capital expenditure. So, free cash flow represents the cash that a company has even after using the money required to maintain or expand its asset base. It is important for raising shareholder value as it allows a firm to pursue opportunities-develop new products or make acquisitions-without capital dilution.
Source - Economic Times