Spending cash from customer sales before paying your suppliers for the goods or raw materials involved sounds like a risky strategy. But occasional controlled periods of 'Negative Working Capital' can help businesses to generate cash quickly and gain a firm grip on their finances.
In this article, we will provide a definition of Negative Working Capital, the advantages and disadvantages it can bring to your business, and offer some tips on how to manage it safely across your organisation.
What is Negative Working Capital?
Negative Working Capital is when a business' 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 firm 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 POS 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. It's crucial to subtract what you owe from what you have – and there’s a working capital formula to help you to calculate these numbers.
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.
- Optimising 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.
Tony Groom, a financial change advisor and chairman of turnaround firm K2 Partners says it's crucial to interrogate what you spend your money on – as well as the reasons behind it – if you do decide to dip 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.
It's important, however, for a business to have a good handle on its standard Working Capital Cycle in order 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?
Utilising 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 muscle 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. One of the first entrepreneurs to use this strategy was Sam Walton, founder of US retail giant WalMart. He ordered vast quantities of stock and sold it on at a profit many weeks before he had to pay for it – freeing up cash to pay for further goods and to expand his business.
Chief Executive of specialist enterprise telecom hardware and software company Track4Services, Derek Greene, says his firm has been taking advantage of a period of Negative Working Capital caused by a slow down in orders thanks to volatile market conditions. He has invested cash into upgrading the functionality of one of its most popular products.
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.
Managing your business' cash flow can be a tough balancing act - especially when the end of the month draws near, and bills are due. With an American Express® Business Card, you get up to 54 days to clear your Card balance, so you can keep your money in the account for longer and get more flexibility in your cash flow.¹
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.
Shares Magazine noted that grocery retailer Sainsbury’s has Negative Working Capital topping well over a billion pounds [1], since Sainsbury's stock is turned rapidly into cash at its checkouts long before it has to be paid for. As Groom puts it, such companies are “effectively funding the business with their suppliers' credit”.
What could be the impact of Negative Working Capital on a company valuation?
According to Groom, if an SME's working capital is seen to be negative, any investor attempting to value the business "will want to see rising revenues". 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 will 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 ensure both the sustainability and growth of your business.
- The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
Sources
[1] Shares magazine, Measuring financial risk and cash conversion cycles
