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

In normal circumstances, working capital will never go negative. Negative working capital (NeWC) is formed when short-term liabilities are used for long-term purposes, or current assets face a blow. For example, using current liabilities or funds for financing long-term assets, abnormal inventory loss, bad debts, consistently selling goods at a loss, etc.

While negative working capital can be a sign of a healthy business that is growing quickly, it can also be an indication of financial distress. This is because the company may struggle to pay its short-term obligations on time, which could damage its credit rating and lead to higher borrowing costs.

This article aims to explain how negative working capital is formed and whether it is good or bad for a business.

Example – Negative Working Capital Cycle

Let us take an example to look at the creation and maintenance of negative working capital with the help of a company’s operating 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 to $500 ($1000-$500)
Accounts receivable created by $600
Step 3:Accounts receivables paid cash $400 & company purchased a fixed asset worth $200, NWC = -100.
Liabilities Side:Accounts payables stand at $1000
Asset Side:Inventory of goods stands at $500
Accounts receivable reduced to $200 ($600 – $400)
Fixed assets stand at $200
Cash created by $200 ($400 – $200)
Step 4:Accounts payable are paid $200, NWC = -100.
Liabilities Side:Accounts payables reduced to $800 ($1000 – $200)
Asset Side:Inventory of goods stands at $500
Accounts receivables stand at $200
Cash reduced to 0 ($200-$200)
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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 as seen in the above example. Let’s learn about various circumstances which can result in negative working capital.

Reasons for Formation of Negative Working Capital

The following points explain the circumstances where the current liabilities can be more than the current assets leading to the formation of 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, it will result in negative working capital.

Seasonal Business

In the case of seasonal business, if the goods are lying in the store for a long and the company cannot sell them, their value will deteriorate. A company that has a seasonal business may have negative working capital during its off-season when sales are slow. During the peak season, the company may generate enough cash to cover its short-term obligations.

Bad Debts

If a company faces a lot of bad debts, it can lead to NeWC. As it reduced the amount of accounts receivables which further reduces the current assets below the level of current liabilities.

Goods Sold at Loss Consistently

It is evident that the value of current assets is more than current liabilities due to margins added in between. If the business continuously sells at a negative margin, it will take current assets below the current liabilities.

Cash Used for Investing in Fixed Assets

Investing in fixed assets, such as property, plant, and equipment (PP&E), can tie up a significant amount of a company’s cash, which can result in NeWC.

Rapid Growth

A company that is growing rapidly may have negative working capital as it invests in new projects, hires new employees, and expands its operations. This can result in a cash flow problem that can cause the company to have NeWC.

If the normal operating cycle continues for a long, a company becomes cash-rich. Above all, if the credit period allowed by accounts payable 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 credit for 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 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. Therefore, NeWC could be advantageous for a business.

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, negative working capital is a bad sign, and the company has all the probabilities of facing financial distress or even bankruptcy. Hence, NeWC can also prove to be disadvantageous.

Sanjay Borad

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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