The Concept of Zero Working Capital

In today’s world of intense global competition, working capital management is receiving increasing attention form managers striving for peak efficiency the goal of many leading companies today, is zero working capital. Proponent of the zero working capital concept claims that a movement toward this goal not only generates cash but also speeds up production and helps business make more timely deliveries and operate more efficiently. The concept has its own definition of working capital: inventories+ receivables- payables. The rational here is (i) that inventories and receivables are the keys to making sales, but (ii) that inventories can be financed by suppliers through account payables.

Zero working capital also refers to the equality between current assets and current liabilities at all times. To avoid excess investment in current assets, firms try to meet their current liabilities out of the current assets fully if they follow this concept. Consequently, smooth and uninterrupted working capital cycle is ensured and it would create an environment in which financial managers always try to improve the quality of the current assets at all times for maintaining cent-percent realization of current assets. This zero working capital always brings a fine balance in financial management. The performance of the financial manager to this endeavor is always reflected.

Companies use about 20% of working capital for each sale. So, on average, working capital is turned over five times per year. Reducing working capital and thus increasing turnover has two major financial benefits. First every money freed up by reducing inventories or receivables, by increasing payables, results in a one time contribution to cash flow. Second, a movement toward zero working capital permanently raises a company’s earnings.

The most important factor in moving toward zero working capital is increased speed. If the production process is fast enough, companies can produce items as they are ordered rather than having to forecast demand and build up large inventories that are managed by bureaucracies. The best companies delivery requirements. This system is known as demand flow or demand based management. And it builds on the just in time method of inventory control.

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.

Clearly it is not possible for most firm to achieve zero working capital and infinitely efficient production. Still, a focus on minimizing receivables and inventories while maximizing  payables will help a firm lower its investment in working capital and achieve financial and production economies.

While the concept of zero working capital may initially appear enticing, it is extremely difficult to implement, for the following reasons:

  • Customers are not willing to pay in advance, except for consumer goods. Larger customers will not only be unwilling to pay early, but may even demand delayed payment.
  • Suppliers typically offer industry-standard credit terms to their customers, and will only be willing to accept longer payment terms in exchange for higher product prices.
  • A just-in-time, demand-based production system can be a difficult concept for customers to accept in those industries where competition is based on immediate order fulfillment (which requires a certain amount of on-hand inventory).
  • In a services industry, there is no inventory, but there are plenty of employees, who are typically paid faster than customers are willing to pay. Thus, payroll essentially takes the place of inventory in the working capital concept, and must be paid at frequent intervals.

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.