A company is said to have negative working capital when its current liabilities exceed its current assets. In other words, the penalties to be paid in a year exceed the existing assets that can be converted into cash over the same period. A buyer generally considers negative working capital unfavourable as it reveals that the business will require an additional capital investment to run after closing. Generally, a working capital ratio of a minimum of 1:1.5 is considered good, showing that the company has solid financial ground in terms of liquidity. It also assures the buyer that the business has sufficient assets to pay off its liabilities/debts.
Did you know? Negative working capital can adversely affect the valuation of a company/ business.
Also reads: What is Window Dressing in Accounting?
Negative Working Capital Formula
Working Capital Formula
Working Capital = Current Assets – Current Liabilities
By contrast, the net working capital metric is similar but excludes two-line items:
- Cash and Cash Equivalents
- Debt and Interest-Bearing Liabilities
The net working capital (NWC) reflects the amount of cash involved in the operations of a business.
Net Working Capital Formula
Net Working Capital = Current Assets (Excluding Cash and Equivalents) – Current Liabilities (Excluding Debt and Interest-Bearing Liabilities)
Net working capital considers the current liabilities and assets to measure the minimum cash balance. The minimum cash balance is the cash required in hand for business operations to function smoothly.
- If Current Assets are more than the Current Liabilities = Positive Working Capital
- If Current Assets are less than the Current Liabilities = Negative Working Capital
What is the Working Capital Cycle?
The working capital cycle is the period/time required to convert current assets into money. Businesses have a firm hold on this as it helps track and control the cash inflow and outflow and how quickly they can adapt to market changes – externally and internally.
The Working Capital Cycle has 4 phases:
- Ensure healthy outflow and inflow of cash.
- Optimise the payment terms/receivables.
- Monitor the time taken to sell the stock.
- Manage the billing, i.e., the time required to repay the creditors.
Utilising cash reserves to settle debts can compound the status of the negative working capital, which in turn will adversely affect the business's growth and functioning.
When a company collects money faster than the time needed to pay its bills, it is termed a negative working capital cycle. In such a scenario, the cash can be utilised/ diverted elsewhere for growth/ expansion of the current business or as any other investment. It is equally important to have a good understanding of a business’s standard working capital cycle to ascertain whether it is feasible to use this capital to settle the recurring expenditures of the company.
An example of a negative working capital cycle is:
25 Inventory Days, 20 Receivable Days – 60 Payable Days = -15 days
It requires 25 days to sell the stock, 20 days to receive the payment, and 60 days to pay off the credit.
Negative Working Capital - Advantages
Negative Working Capital produces rapid development when invested methodically. Using the excess funds (before all payments are fulfilled) to spend on boosting inventory and developing the firm. This method can help a company's financial condition and expansion if performed correctly.
Negative Working Capital - Disadvantages
- Businesses with negative working capital miss opportunities to expand, innovate, or compete. The expansion points are void because investors noticing negative working on the balance sheet associate it with poor sales or holding back of customer invoices.
- A business dips into its negative working capital and shows a lack of ready cash. In such a situation, the company becomes vulnerable as the need for finances at short notice for legal expenses or any other unforeseen expense makes it difficult.
- Managing the inflow and outflow of cash becomes problematic when the creditor payments are due and the business is short of money.
What types of companies typically have Negative Working Capital?
The following companies usually have a negative working capital:
- Fast food restaurants.
- Large food stores.
- Online and discount retailers.
- Telecom companies.
In such companies, the stocks are mostly converted into cash before the payments are due. So, such companies successfully fund the business with the credit provided by the suppliers.
Impact of Negative Working Capital on the valuation of a company
The negative working capital harms the valuation of a business. The investors valuing a business want to see a picture of rising revenues. They do not wish to see a picture of poor liquidity. A company possessing higher current liabilities than current assets will show poorly on the valuation front.
How to avoid Negative Working Capital?
Look at your working capital. List incoming and outgoing. This will help realise the problems that could occur in the future. Find out where the resources are being wasted or held for a long time.
It is advisable to shorten the Working Capital Cycle to avoid Negative Working Capital. The following should be considered to avoid negative working capital:
- Tracking the working capital ratio.
- Automation of financing processes of the business.
- Improvement in stock/inventory management.
- Finding out ways to increase the sales revenue.
- Elimination of undesired/ unessential expenses.
Also read: What is Process Costing?
We hope this article has been of help in providing information about negative working capital. Here at Khatabook, we provide precise and accurate information to our readers. Managing the working capital is very important for the company/business’s health. A positive working capital reflects the company has substantial liquid assets to meet short-term obligations such as interest payments on loans, amounts to creditors, etc. It also has money to invest in growth and expansion. A negative working capital shows that the business lacks good financial standing.
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.