What is Negative Working Capital?
Negative working capital (NeWC) is a financial situation where a company’s current liabilities exceed its current assets. In simpler terms, this means that the company owes more money to creditors than it has on hand to cover those debts. 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?
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. Therefore, the formula to calculate negative working capital is the same as that of net working capital.
Let’s consider a retail business that operates on a cash basis. This means it collects cash from customers at the point of sale. This business purchases inventory from suppliers on credit, meaning it doesn’t have to pay for the inventory immediately. In this scenario, the business has negative working capital.
Consider the following details regarding current assets and current liabilities:
|Current Liabilities||Amt. ($)||Current Assets||Amt. ($)|
|Other Short-term Debt||30,000||Inventory||20,000|
|Total Current Liabilities||70,000||Total Current Assets||50,000|
The net working capital of the business is:
Net Working Capital = Current Assets – Current Liabilities
= $50,000 – $70,000
This negative working capital indicates that the business is using its suppliers’ credit to finance its inventory purchases and not maintaining adequate cash reserves to cover its debts. However, since the business collects cash from customers quickly and efficiently, it can turn over inventory quickly and pay off its debts before they become due. Therefore, in this scenario, negative working capital can be a deliberate strategy to maintain positive cash flow and reduce the need for external financing. Let’s learn how.
Impact of Negative Working Capital
Negative working capital can have both positive and negative impacts on a business. On the positive side, it can improve cash flow, reduce the need for external financing, and increase efficiency by freeing up resources that would otherwise be tied up in working capital. By using short-term financing to cover operating expenses and acquire inventory, businesses can operate more flexibly and respond more quickly to changes in the market.
However, it can also have negative impacts. It can increase the risk of default if a business is unable to pay its bills on time, damage supplier relationships, and limit a business’s growth potential if it is unable to obtain the financing it needs to expand operations. Negative working capital can also reduce a company’s creditworthiness and make it harder to obtain financing in the future. Therefore, it’s important for businesses to carefully manage their working capital position and adjust their strategy as necessary to maintain financial stability and sustainability.
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. Therefore, one must analyze whether the negative working capital is good or bad.
Impact on Cash Flow
Negative working capital creates excess cash flow because it means that a business is financing its operations with short-term liabilities, such as accounts payable, trade credit, and other current liabilities. By delaying payments to suppliers while quickly turning over inventory and collecting payments from customers, a company can operate with a negative working capital position. These liabilities don’t require immediate payment and can provide a source of funding for a business to operate without tying up too much of its own capital.
By operating with negative working capital, the company can improve its cash flow, reduce its need for external financing, and operate more efficiently. However, it’s important to note that managing negative working capital requires careful attention to cash flow management and supplier relationships. If a company is unable to pay its bills on time, it can damage relationships with suppliers and hurt its creditworthiness, which can make it harder to obtain financing in the future.
Impact on Business Valuation
Negative working capital can impact the valuation of a business in several ways. In some cases, it can be viewed positively by investors as it can indicate a highly efficient business model that is able to operate with minimal working capital. This can lead to a higher valuation of the business as investors may be willing to pay a premium for a well-managed business that is able to generate high returns with minimal investment in working capital.
On the other hand, it can also be viewed negatively by investors if it indicates that a business is experiencing financial distress or is unable to pay its bills on time. This can lead to a lower valuation of the business as investors may be hesitant to invest in a business that is struggling to manage its cash flow and working capital.
Continue reading about other Types of Working Capital.
Frequently Asked Questions (FAQs)
It indicates that current liabilities have financed 100% of current assets and a portion of fixed assets (by the amount it is negative).
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.