This article is intended for general informational purposes only and does not constitute legal or financial advice or an opinion on any issue. It should not be regarded as comprehensive or a substitute for professional advice.
Business owners may find the concept of negative working capital as something that their businesses should always avoid. But occasional controlled periods of negative working capital may help businesses to generate cash quickly and gain a firm grip on their finances.
In this article, you will learn about negative working capital, the advantages and disadvantages it may bring to your business, and offer some tips on how to manage it safely across your organization.
What is Negative Working Capital?
Negative working capital is when a business's current liabilities exceed its current income and assets. A temporarily negative working capital typically occurs when a business makes a large purchase, such as investing in more stock, new products, or equipment.
Clearly, no company wants to put itself in a position where it can’t pay staff or its bills, but dipping into negative working capital isn't necessarily a risky move. While it’s generally not viewed as positive, certain businesses and industries experience periods of negative working capital without feeling a pinch. For example, in hospitality and retail, where Point Of Sale transactions appear almost instantly, short periods of negative capital don’t matter as much.
Whatever your order book looks like, you always need to know where you stand with your working capital.
Working Capital = Current Assets - Current Liabilities
Importance of Understanding Your Working Capital Cycle
The working capital cycle is the time it takes to turn current assets into money in the bank. Successful businesses should have a complete grip on this since it helps them to keep control of their cash flow and to understand how agile they can be.
The working capital cycle comprises four phases:
● Ensuring healthy inflows and outflows of cash
● Optimizing customer payment terms or receivables
● Keeping tabs on the time taken to sell inventory
● Managing billing, which is how long you have to pay suppliers
It’s vital for business owners to understand what you’re spending money on and why, before you decide on dipping into negative working capital. For example, using cash reserves to pay off debts could compound your negative working capital state and make it difficult to get the balance swinging in a positive direction to fuel business growth.
What is a Negative Working Capital Cycle?
A negative working capital cycle is when a business collects money at a faster rate than the time required to pay its bills. This means the business can free up cash quickly for use elsewhere that would otherwise be stuck in the cycle.
BUSINESSES THAT HAVE NEGATIVE WORKING CAPITAL HAVE LITTLE HEADROOM TO TAKE UP THE MANY OPPORTUNITIES THAT COME THEIR WAY TO INNOVATE, EXPAND, OR TAKE OVER RIVALS.
It's important, however, for a business to have a good handle on its standard working capital cycle to understand if it can afford to use negative working capital to cover suppliers’ bills, payroll, and other regular expenses with no risk.
Is Negative Working Capital Good or Bad?
Utilizing negative working capital is a strategy often followed by fast-growing, high-turnover companies that don’t supply goods on credit. They have tight control over their inventory, strong brands, and the power to bargain with suppliers.
Advantages of Negative Working Capital
A key advantage of negative working capital is the ability to invest strategically to fund fast growth.
Disadvantages of Negative Working Capital
Businesses that have negative working capital have little headroom to take up the many opportunities that come their way to innovate, expand, or take over rivals. It can also impact plans to fund expansion, as investors who see negative working capital on the balance sheet may take it as a sign that sales are poor, or that customer invoices are not being paid.
A lack of ready cash can also leave a business vulnerable, since more funds may be needed at short notice for anything from repairs, legal expenses, or riding out an unforeseen financial downturn.
What Types of Companies Typically Have Negative Working Capital?
Large food stores, online and discount retailers, fast food restaurants, utilities, software, and telecom companies are among those most likely to have negative working capital.
What could be the Impact of Negative Working Capital on a Company Valuation?
Investors who may be attempting to value a company will want to see rising revenues if a company has many periods of negative working capital in their balance sheets. That’s because falling revenues often signal poor liquidity – an inability to readily convert any assets the company owns into cash. A company that consistently has more current liabilities than current assets will not look like an attractive prospect to investors.
How to Avoid Negative Working Capital
Take control of your working capital by picking the period you want to plan for, and list all your incomings and outgoings. This cash flow forecast can help identify shortfalls ahead, potential problems with incoming payments, and help you to see where resources are being wasted or tied up in stock for too long. It's also important to ensure pricing and invoice decisions are not made in silos. For example, a central finance drive to bring in cash more quickly might be undermined by longer credit terms being offered elsewhere within the company.
A key objective in avoiding negative working capital should be shortening your working capital cycle. Here’s a useful checklist to get you started:
● Track your working capital ratio.
● Automate your business financing processes.
● Improve your inventory management.
● Look for ways to boost your sales revenue.
● Avoid unnecessary outgoings and expenses.
Effective working capital management – safely freeing up cash that would otherwise be locked away for longer – is an important business tool in your journey to avoid negative working capital and help ensure both the sustainability and growth of your business.