Negative working capital (NeWC) is defined as the excess of current liabilities over current assets. While calculating the net working capital, if the figure is found negative, it is called negative working capital. We can also say it is negative net working capital.
This situation indicates that current liabilities have financed 100% of current assets and a portion of fixed assets (by the amount it is negative).
How to Calculate the Negative Working Capital and its Magnitude?
Assume the following balance sheet:
|Liabilities||Amt. ($)||Assets||Amt. ($)|
|Share Capital||100,000.00||Fixed Assets||2,000,000.00|
|Long Term Debt||1,000,000.00||Current Assets||800,000.00|
|Total Liabilities||2,800,000.00||Total Assets||2,800,000.00|
Net Working Capital (NWC) = Current Assets – Current Liabilities = 8,00,000 – 17,00,000 = – 9,00,000
As per the definition above, the magnitude of negativity is $900,000. Let us try to analyze the situation. Here, 100% of the current assets are financed by the current liabilities, and it has also financed 45% of Fixed Assets. The magnitude of NWC is reasonably high here as it is financing nearly 50% of the fixed assets also.
How Negative NWC is formed?
Negative NWC normally forms with companies like Amazon, which sells on cash but obtains goods on credit. We have analyzed the case in more detail in whether the negative working capital is good or bad.
Impact of Negative Net Working Capital (NeWC)
Now, if you have to pay off all the current liabilities, we have only $0.8 million in current assets to pay them assuming they are liquid. What about the remaining liability of $0.9 million? What will you do?
- Will you have to sell off your fixed asset to pay the current liability?
- Are the fixed assets liquid?
- Will you get the same amount as mentioned in the balance sheet if you sell off the fixed asset?
The answer to all these questions, in all probability, is a big “NO”. It simply shows you a way towards filing for BANKRUPTCY. This is why this situation is not desirable to the companies.
NWC simply means very high dependability on the accounts payables i.e. creditors or suppliers. This means if they withdraw their support, you will have to wind up the business. Do they have sufficient reason to withdraw? YES, because this much of the balance of current liabilities must have been accumulated by not paying the accounts payable on time. Obviously, if there is no timely payment to a supplier, he would not wish to continue with those buyers. He will find all the possibilities of breaking the relationship.
Exceptions to the above can be companies who sell goods on cash but get credit while purchasing the goods and their inventory turnover is also high. Such companies will always have NeWC with no harm to their operating cycle.
NeWC defies the Principles of Financial Management
There is a general discipline of financial management that long-term assets should be financed by long-term sources of funds and short-term assets with short-term sources. It is still tolerable to fund short-term assets with long-term sources but vice versa is not at all desirable for a business. Based on the established principle of funds management also, NeWC is not desirable.
Advantages and Disadvantages of Negative Working Capital (NeWC)
There may be some advantages and many disadvantages of having NeWC. The advantage of negative working capital may be of saving in cost of short-term funds. It is believed that there is no explicit cost of trade credit. We will not talk about the implicit costs of trade credit here. Disadvantages of Negative Working Capital include the high risk of bankruptcy, lost trade discounts, lower creditability in banks, potential risk of winding up an application by creditors, bad supplier relationships, etc. There may be a host of other disadvantages.
Continue reading about other Types of Working Capital.
- How Negative Working Capital is formed? Is it Good or Bad?
- Classified Balance Sheet – Meaning, Importance, Format And More
- Importance of Operating Capital in Business
- Accounting Policies – Meaning, Uses, Types, and Importance
- Disadvantages of Negative Working Capital
- Working Capital Calculation – Percentage of Sales Method