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Fundamental analysis is considered to be the holy grail of stock investors. Warren Buffet claims to have amassed his fortune thanks to it. People who consider him to be a role model swear by the effectiveness of this method. The media also cannot stop singing praises. However, ask any Forex trader whether they follow fundamental […]
Financial Modelling in Real Estate
Financial modeling has become an essential part of most real estate transactions today. This is because of the fact that real estate deals today are complex are undertaken not only by individuals but by corporations who specialize in such transactions. Take the case of Real Estate Investment Trusts (REITs), for example. These trusts are organizations […]
Valuing Preference Shares Using Dividend Discount Model
The dividend discount model is also used to measure the value of preference equity in addition to forecasting the value of ordinary equity. There are certain assumptions and clarifications that need to be made regarding the use of dividend discount model for valuing preference equity. The purpose of this article is to provide this information […]
Ordinary Annuity vs. Annuity Due
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Golden Rules of Accounting – 3 Main Principles
While the system of debit and credit is the foundation for maintaining balance and accuracy, it can often feel overwhelming for beginners and even for clerical staff who handle day-to-day bookkeeping. The Golden Rules of Accounting are designed to simplify these concepts into actionable principles that anyone can use. These rules break down the most […]
Traditional financial analysts would consider a negative working capital i.e. having more current liabilities than current assets, a sign of imminent danger. This view was deep rooted in the belief that a company must always have sufficient cash on hands to meet its short term liabilities failing which the credit will dry up and the company will get into a lot of trouble.
However, of late negative working capital has actually become a norm in many industries such as retail. There are thriving businesses such as Wal-Mart that have based their entire business strategies around negative working capital. This paradigm shift in the opinion about negative working capital is what makes it an interesting subject to read further about. This article will provide more details.
As per traditional analysis, investors would look at the current ratio of a company with negative working capital with great concern. As the current assets will be less than the current liabilities, this would signal imminent danger to them. The current ratio of such a company would be less than 1. However as we will see it is more than healthy.
In some businesses like in retail, inventory is taken from the suppliers on sale or return basis. This has become the norm after big ticket retailers such as Wal-Mart pretty much control the shelf space which in turn controls what people buy.
Suppliers of Wal-Mart therefore find Wal-Mart in a commanding position and therefore are more than happy to extend liberal trade terms. These terms state that Wal-Mart must make the payment for the purchases in 45 days if they are able to sell the inventory. In case they are not able to sell it, the suppliers will be more than happy to take the goods back.
Wal-Mart while on one hand has negotiated a 45 day credit for itself, sells to customers on cash. Assuming a period of 10-15 days to actually sell the inventory, Wal-Mart still has one full month of interest free cash for itself. They can use this cash for their treasury operations or to fund future growth of their company. In case they fail to sell the goods within 45 days, they just return the inventory or get an extension.
Hence, a negative working capital scenario has become beneficial for many companies who meet their operating expenses out of interest free credit extended by the suppliers.
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