Running a business is a challenging task that requires continuous financial planning and monitoring. Understanding the difference between working capital and negative working capital is crucial in evaluating a company's financial performance. Negative working capital is when a company's current liabilities are more than its current assets, creating a shortfall in its working capital. Negative working capital can have both advantages and disadvantages, depending on the business's circumstances and needs. This article aims to provide an in-depth understanding of negative working capital, its differences from working capital, its advantages and disadvantages, and how loans can help businesses facing negative working capital.
Formula for Negative Working Capital
In accounting books, working capital is usually explained as:
Working capital formula
Working capital = Current assets – Current liabilities
On the other hand, the net working capital (NWC) is quite similar, but it specifically excludes two items:
- Cash and cash equivalents
- Debt and interest-bearing securities
The NWC figure shows how much cash is tied up in a company's day-to-day operations.
Net working capital formula (NWC)
Net working capital (NWC) = Current assets (excluding cash and equivalents) – Current liabilities (excluding debt and interest-bearing liabilities)
While items like accounts receivable (money owed to the company) and accounts payable (money the company owes) are operational, cash and debt are not directly involved in generating revenue.
NWC focuses on the operating assets and liabilities to determine the minimum cash needed to keep the business running smoothly.
- If current assets are greater than current liabilities - Positive working capital
- If current assets are less than current liabilities - Negative working capital
Causes of Negative Working Capital
There are several reasons why a company might face negative working capital. In some industries, negative working capital is quite common, while in others, it indicates problems with financial management. Here are some of the main reasons why a business might see its current liabilities exceed current assets:
- High inventory turnover
Negative working capital is common in industries with high inventory turnover. This includes businesses like restaurants, grocery stores, and retailers who don’t offer credit to customers and have good control over stock. These businesses collect money quickly from sales, often faster than they need to pay their suppliers. - Large purchases
Businesses, regardless of industry, might temporarily face negative working capital after making a big purchase. This could include buying new equipment, products, or making investments to support future growth. - Poor invoicing
Many businesses struggle with getting clients to pay invoices on time. Delayed payments or long payment terms can cause cash flow problems when the business needs to pay its own bills before receiving money from customers - Financial struggles
For some businesses, poor financial management leads to a cycle of negative working capital. They may struggle to meet their financial obligations or end up borrowing more (increasing debt) to keep the business running
Example Calculation of Negative Working Capital
Let us take a look at an example of negative working capital, using a simplified model for a company operating in the retail sector.
Model assumptions
From Year 1 to Year 2, the company’s operating current assets and liabilities change as follows:
Current assets
- Accounts receivable: Rs. 60 crore → Rs. 80 crore
- Inventory: Rs. 80 crore → Rs. 100 crore
Current liabilities
- Accounts payable: Rs. 100 crore → Rs. 125 crore
- Accrued expenses: Rs. 45 crore → Rs. 65 crore
Year 1 working capital calculation:
Current assets = Rs. 140 crore
Current liabilities = Rs. 145 crore
Working capital = Rs. 140 crore – Rs. 145 crore = - Rs. 5 crore
Year 2 working capital calculation:
Current assets = Rs. 180 crore
Current liabilities = Rs. 190 crore
Working capital = Rs. 180 crore – Rs. 190 crore = - Rs. 10 crore
In this example, the company experiences negative working capital in both years, driven by several factors:
- Increase in accounts receivable: The company has sold goods on credit, leading to a rise in accounts receivable, which is a cash outflow of Rs. 20 crore (from Rs. 60 crore to Rs. 80 crore). This means the company has tied up cash in sales that have not yet been collected
- Increase in inventory: The company’s inventory has increased by Rs. 20 crore (from Rs. 80 crore to Rs. 100 crore), which represents another cash outflow. The company has purchased more stock on credit, but has not sold it yet, leading to higher unsold inventory
- Increase in accounts payable: The company’s accounts payable has risen by Rs. 25 crore (from Rs. 100 crore to Rs. 125 crore). This represents a cash inflow, as the company has delayed paying its suppliers, effectively using credit from them
- Increase in accrued expenses: Similarly, the company’s accrued expenses have increased by Rs. 20 crore (from Rs. 45 crore to Rs. 65 crore), which is another cash inflow, as the company is postponing some payments
In total, the increase in accounts payable and accrued expenses (cash inflows) helps offset the cash outflows caused by the rise in accounts receivable and inventory. However, due to the greater increase in liabilities than assets, the company ends up with negative working capital in both years.
This could be a normal situation in certain industries, like retail or fast-moving consumer goods (FMCG), where companies often operate with negative working capital, using suppliers' credit to fund their operations. However, it may indicate financial strain if the business struggles to collect payments or manage its inventories effectively.
How to fix negative working capital
Since negative working capital can pose a serious risk to a business, it is important to find ways to improve it. Here are some strategies that can help strengthen your financial position:
- Better understand cash flow, accounts receivable, and more
Business owners should start by getting a clear understanding of their cash flow. Using a balance sheet to track income and expenses can reveal where money issues might be coming from, contributing to negative working capital. It is also important to monitor things like accounts receivable and how long it takes to sell through inventory. - Optimise billing cycles
With this information in hand, business owners can negotiate better payment terms with their suppliers to optimise billing cycles. Aligning expenses with expected sales or securing longer payment terms can help ensure that billing cycles match your business’s cash flow needs. Vendors are more likely to offer these terms to reliable customers with a good history of on-time payments. - Improve your invoicing practices
Difficulty collecting payments from slow-paying customers is a common reason for negative working capital. To tackle this, ensure that invoices are sent on time and follow up to make sure payments are received as scheduled. You could also consider offering shorter payment terms or even introduce early payment discounts or late fees. These steps can help you get paid faster, giving you enough cash to cover your expenses. - Use invoice factoring
Another option is invoice factoring. This involves selling your unpaid invoices to a third-party factoring company for cash. The factoring company advances up to 90% of the invoice amount, and once they collect the payment from your customer, you receive the remaining balance, minus the factoring fees. This allows you to avoid chasing late payments and get immediate cash to keep your business running.
Difference between working capital and negative working capital
Working capital refers to the difference between a company's current assets and its current liabilities. It is used to finance a company's short-term operational needs, such as inventory, credit sales, salaries, and rent. A positive working capital indicates that the company has more current assets than current liabilities. This gives the company liquidity to meet its short-term obligations and invest in new opportunities.
On the other hand, negative working capital occurs when a company's current liabilities are more than its current assets. This means that the company has less liquidity to meet its short-term obligations, leading to cash flow problems. Negative working capital can arise from various reasons such as a mismatch in payment terms with suppliers and customers, excessive inventory, or poor forecasting of cash flows.
Advantages of negative working capital
Negative working capital is not always a bad sign as it can have some advantages for businesses. The most significant advantage is that it enables companies to use their suppliers' credit terms to finance their operations. For instance, if a company has negative working capital, it can borrow money from its suppliers by delaying payments. By extending supplier credit terms, companies can use their cash to invest in growing their business, such as expanding their product line or entering new markets.
Another advantage of negative working capital is that it can encourage companies to be more efficient in managing their cash flows. A company with negative working capital will have to manage its expenses more carefully to avoid a liquidity crisis. This can lead to better inventory management, debt management, and overall financial discipline, which are valuable skills for any business.
Disadvantages of negative working capital
While negative working capital can have certain advantages, it is generally considered a negative sign for businesses. The most significant disadvantage is that it can lead to a liquidity crisis, making it difficult for companies to meet their short-term obligations. If a company has negative working capital, it may struggle to pay suppliers, staff salaries, or other expenses. This can damage the company's reputation, leading to difficulties in securing credit or attracting new customers.
Another disadvantage of negative working capital is that it can limit a company's growth potential. If a company is continually struggling to meet its short-term obligations, it may not have the financial resources to invest in new opportunities or expansion plans. This can limit its ability to source new customers, increase sales revenue, or cut costs.
Conclusion
In conclusion, understanding negative working capital is essential for businesses as it can impact their short-term financial obligations and their long-term growth prospects. While negative working capital can have certain advantages, it is generally considered a negative sign and can lead to a liquidity crisis.
