How Negative Working Capital is formed? Is it Good or Bad?

In normal circumstances, working capital will never go negative. Negative working capital is formed when short-term liabilities are used for long-term purposes, or current assets face a blow, e.g., current liabilities or funds used for long-term assets, abnormal inventory loss, bad debts, consistently selling goods at a loss, etc. Negative Working Capital Good or Bad is explained in the article.

Let us look at the creation and maintenance of net working capital with the help of a company’s operating cycle.

Starting the cycle,

Step 1:Creditors extend goods on credit by $1000, NWC = 0.
Liabilities Side:Accounts payables created by $1000
Asset Side:Inventory of goods created by $1000
Step 2:Inventories worth $500 sold to accounts receivables @ 20% margin for $600, NWC = +100.
Liabilities Side:Accounts payables stand at $1000
Asset Side:Inventory of goods reduced by $500 ($1000-$500)
Accounts receivable created by $600
Step 3:Accounts receivables paid cash $400, NWC = +100.
Liabilities Side:Accounts payables stand at $1000
Asset Side:Inventory of goods stands at $500
Accounts receivable reduced to $200 ($600 – $400)
Cash created by $400
Step 4:Accounts payable are paid $300. NWC = +100.
Liabilities Side:Accounts payables reduced to $700 ($1000-$300)
Asset Side:Inventory of goods created by $500
Accounts receivable stands at $200
Cash reduced by $100 ($400-$300)
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We noticed that if the same cycle carries on, with every new cycle, the current assets will keep on increasing because of the addition of margin while transferring the goods from accounts payable to accounts receivable. Therefore, in a normal situation, working capital will not go negative. It will always remain positive.

For working capital to go negative current assets must go below the current liabilities.

Situation for Negative Working Capital

Abnormal Loss in Inventory

If there is a loss in inventory due to wastage of material, fire in the store, theft, etc., or any such reason which will diminish the value of inventory in the balance sheet will result in negative working capital. If the goods are lying in the store for a long and the company cannot sell them, the value will deteriorate.

Bad Debts

If a company faces a lot of bad debts, it can lead to NeWC. It may be because of a bad selection of customers, credit extensions to customers with bad credit records, an excessively aggressive selling approach, etc.

Goods Sold at Loss Consistently

We saw above that the value of current assets is more than current liabilities due to margins added in between, and if we are selling at a negative margin, it will take current assets below the current liabilities.

Cash Used for Investing in Fixed Assets

If the normal operating cycle continues for a long, a company becomes cash-rich. Above all, if the credit period allowed by accounts payable, i.e., 30 days, is more than the period it takes to complete the remaining cycle (Inventory >> Accounts Receivables >> Cash), the company will become super cash-rich.

Another far-end example could be taking goods on the credit of 30 days and selling them in cash within 10 days will create such a situation. Such companies partly utilize this cash to invest in fixed assets or long-term investments. This will make their working capital negative but still have a smooth operating cycle.

Is Negative Working Capital Good or Bad?

Now, we can comment on whether negative working capital is good or bad. The answer is apparent that it will depend upon the reason why it is going negative. Suppose the reason for NWC going negative is abnormal inventory loss or a high level of bad debts or consistently selling goods at a loss. Yes, the negative working capital is a bad sign, and the company has all the probabilities of facing financial distress or even bankruptcy.

Suppose the reason is an investment of extra available cash in Fixed Assets or Long Term Investments without disturbing the company’s operating cycle. In that case, the negative working capital is a sign of efficient management. Such situations appear for giant companies having muscle power of bulk demand and who can command credit terms with the suppliers. Also, companies having cash sales but credit purchases can create such a situation. 

Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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