Beware the working capital tipping point

Zombie companies

Traditionalists among risk analysts have long complained about the dangers of loading up a company’s balance sheet with debt and limiting the equity commitment of the owners. The result is the much-discussed ‘zombie’ company, technically insolvent and dependent on profit and cash generation to stay alive.

Year after year the number of UK businesses operating this way grows. In June 2022 our research revealed that there were over a quarter of a million zombie companies in the UK, with a combined deficit of £300bn.

The rise of the ‘NWC’

Now we’re seeing the emergence of a new and even more concerning trend – the ‘NWC’, a company with negative working capital. In essence this means that its ‘quick assets’ like inventory, trade receivable and cash are less than its liabilities like trade creditors and HMRC, which are due for payment within a year. Our research in June 2022 identified 178,000 such businesses, which coincidentally also had a combined negative working capital of £300bn. The number of NWCs had risen by over 40% in the previous two years.

Why is negative working capital a problem?

Credit rating

A company with negative working capital doesn’t usually come up smelling of roses when it’s exposed to the algorithms of credit rating agencies. This could deter customers from buying from it and potential new suppliers from engaging. Existing suppliers may find getting cover from trade insurers a problem, with a knock on effect in both cash flow and the supply chain.

Those fragile quick assets

Every major element of the current assets section can be subject to unexpected negative swings. Inventory can deteriorate or go out of fashion, leading to heavy clearance discounting or year-end write downs of slow-moving items. Profits are affected, so is cash flow.

Bad debts always happen unexpectedly and quite often from the supposedly least risky customers. They not only worsen the working capital equation, but they can play absolute and immediate havoc with cash flow if the business is funded through some sort of receivables finance, such as invoice discounting.

Cash is cash, but can bleed away in a loss-making business or disappear to meet unanticipated expenditure.

Trouble on any of these balance sheet lines can thrust a business into a NWC position, or worsen an existing one.

Those escalating current liabilities

Accounting for trade creditors is notoriously prone to understatement, but even if accurate, numbers can grow as cash is sucked out of a poorly-performing business and creditor payments have to be delayed. Equally, they can shrink if suppliers take fright at a business’s finances and shorten credit terms, tighten credit limits or even demand payment in advance of delivery.

Short term funding, such as overdrafts, asset-based facilities and the short-term portion of loan balances can balloon remarkably quickly if there are trading problems, or to support rapid growth.

What’s the answer to negative working capital?

Every situation is different, but the three clearest answers are to:

• inject extra equity, which boosts the cash position;
• renegotiate funding facilities, for example to turn an overdraft into a term loan;
• sell surplus fixed assets to generate cash to reduce short term liabilities.

Spotting the problem early and acting decisively

Management account trends, looked at in conjunction with budgets and forecasts should identify the drift towards negative working capital, before it emerges as a deeply inconvenient shock in a company’s annual financial statements.  If that’s where the business is heading, it really is ‘Action This Day’ – prompt and decisive remedial action should be a top priority.

Getting advice

Raising extra equity or renegotiating lending facilities are areas for experts, at least if optimal solutions are to achieved. As well as their expertise and experience, using independent advisers increases the bandwidth and alleviates the strain on management teams.