Why does customers paying upfront result in negative NWC
Question 19 from M&I400 Accounting Section: What does negative Working Capital mean? Is that a bad sign?
The answer says "Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency."
Some questions:
1: Why is McDonald's included to this list? I can see how "pay upfront" can hold for Amazon and Wal-Mart but not for McDonald's.
2: Why would using cash to pay off Accounts Payable "rather than keeping a large cash balance on-hand" reduce Working Capital or make it negative? Wouldn't both decrease by the same amount on the balance sheet (cash being part of current assets and Accounts Payable being part of current liabilities) and thus for NWC=current assets - current liabilities we would have no change?
Thank you in advance for your patience with my confusion.
Agree it makes little/no sense. Customers of Wal-Mart and McDonalds don't pay "upfront." My only guess is that the text you copied was very poorly worded and was meant to describe WalMart and Amazon as customers, i.e. when they are buying products, raw materials, ingredients, etc from suppliers.
Negative net working capital is (generally) a sign of efficiency though, in that it indicates that a business can and does partially finance itself for free, with cash that comes in today, and goes out tomorrow, the next day, the day/week/month after that. In that case, the suppliers to amazon, wal-mart, McD are getting paid upfront by those companies, using that cash for some near-term corporate purposes, and delivering product to their customers later.
Hmm curious what others think, however this has always been my interpretation of the answer for Question 2.
I think the question in particular refers to WC {(CA - Cash) - (CL-Debt)} as a part of the cash flow statement rather than regular WC (CA-CL). So the more positive WC is in terms of their balance sheet accounts the more negative cash balance (cash outflow). Cash outflow occurs as current assets go up.
Increasing cash doesn't have any effect on the total of (CA-Cash) but an has effect on the total of (CL-Debt). As the amount of Cash balance grows the total current assets amount also grows proportionately, since cash is also apart of total current assets. Cash is not apart of (CL-D) however, and if we reduced accounts payable it would just reduce CL causing an increase in cash outflow.
So you know how when you are calculating free cash flow from EBITDA, you subtract additions to net working capital? That means additions to net working capital (in other words making it more positive) is a free cash flow outflow. This is because free cash flow is seen as the money available to distribute to debt and equity holders. As such, increased in net working capital are seen as investment into the business. By that logic, net working capital calculation should not include cash because it is a cash out flow.
https://corporatefinanceinstitute.com/resources/knowledge/finance/what-…
I don't think this answers your whole question but should address the cash on the balance sheet part.
Check out "Negative working capital" by Finance|able. The article is a little cheesy but it helped me understand the topic really well. At a basic level, negative NWC is a free loan for the business and as long as the business is growing it results in a cash inflow for the business. There are two main drivers of negative NWC, of which, one is deferred revenue.
Take Netflix for example. A customer buys a 1 year subscription for $120 on January 1st. Netflix debits cash and credits deferred revenue, and then each month debits deferred revenue by $10 to represent the service being provided and the balance flows to retained earnings. Essentially, through the framework of negative NWC as a free loan, deferred revenue is simply cash that Netflix is free to spend so long as they're able to provide the customer with the account / service that they already paid for. This means they have a non-interest bearing loan in a way that can be used to grow the business however they see fit.
I recommend checking out the article in case you're wondering about accounts payable (the other driver of negative NWC) and how that functions if you're interested.
Hope this helps.
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