What is Negative Working Capital and How to Track It

Introduction

Working capital is one of the critical elements that helps determine the operational efficiency and liquidity of a business. While positive working capital indicates sound financial health, negative working capital requires careful management by CFOs and finance leaders. Despite seeming counterintuitive, negative working capital is not always a bad sign for businesses. 

Negative working capital occurs when a business decides to spend more cash from revenue before settling short-term obligations and supplier payments. It means their current liabilities will be greater than their current assets. The problem arises when businesses lack reserves to meet their operational expenses. 

This blog provides you a detailed overview of negative working capital – what it means, the reasons behind it, whether it’s necessarily bad,, ways to avoid it, and how automating cash management can enhance working capital efficiency.

What Does Negative Working Capital Mean?

Negative working capital occurs when a company’s current liabilities exceed its current assets. It can result from incurring large short-term debt, increased accounts payable, or a shortage of current assets. It can indicate potential liquidity issues and an inability to meet short-term obligations.

For instance, grocery stores, restaurants, and retailers often operate with negative working capital because, while they receive payments immediately against sales, they pay their suppliers later. This means the value of their current assets is lower than the amount due to suppliers. 

However, if working capital remains negative for a longer period, it means businesses might be approaching a hands-to-mouth situation and struggling to meet their day-to-day expenses. They may also have to go for short-term debts or stock issuances to fund their working capital. In such cases, businesses must proactively identify and solve the issues causing negative working capital. 

An example for negative working capital 

Let’s take an example of a XYZ company that has the following current assets and current liabilities. 

Current Assets	Amount ($)
Cash and Cash Equivalents	$10,000
Accounts Receivable	$20,000
Inventory	$15,000
Short-Term Investments	$5,000
Total Current Assets	$50,000

Current Liabilities	Amount ($)
Accounts Payable	$30,000
Short-Term Loans	$25,000
Accrued Expenses	$10,000
Short-Term Portion of Long-Term Debt	$5,000
Total Current Liabilities	$70,000

Working Capital = Current Assets – Current Liabilities

Working Capital	Amount ($)
Total Current Assets	$50,000
Total Current Liabilities	$70,000
Working Capital	-$20,000

Here, the company has negative working capital. It means it has more current liabilities than working capital and may face challenges in meeting its short-term debt obligations with current assets alone in the long run. 

However, it can also mean that the company receives more cash before it pays its creditors. It might have a higher inventory turnover rate, faster conversion of stock to cash and be able to carry out business operations without friction.

Advantages of negative working capital 

Negative working capital can benefit companies that have a higher inventory turnover. When businesses can sell their stock faster than they have to pay their suppliers, it enables them to leverage their suppliers’ credit terms to fund their operations. 

Businesses can immediately utilize the cash received from selling inventory to finance strategic growth opportunities. They can also use the cash to expand their business, purchase additional inventory and upgrade products and services. However, to benefit from negative working capital, a business must have a healthy cash flow from its inventory turnover. 

Disadvantages of negative working capital 

Negative working capital can have manifold consequences for businesses that don’t generate large amounts of cash flow from inventory turnover. Businesses with negative working capital often have insufficient liquid assets to cushion operating expenses, resulting in situations where they have to turn to debts or other funding like invoice factoring to settle repayments. 

Negative working capital can limit opportunities to expand or fund growth innovations. It makes navigating through contingencies difficult, especially during economic downturns changing market conditions, and impacts budgets and operations. 

What Does Positive Working Capital Mean?

When a business’s current assets exceed more than its liabilities, it denotes they have a positive working capital. It indicates that a business has sufficient reserves to settle its short-term obligations and invest for better returns. A positive working capital indicates a stable financial performance. 

However, having significant businesses with too much working capital does not necessarily always indicate better financial performance. It can often mean that a business has too much-working capital tied up in unused and unsold inventories. It can also indicate that a business has many means they may have unprocessed account receivables due from past sales, indicating ineffective utilization of a business’s resources.

Moreover, the additional funds that get stuck with unsold stock and receivables are not financed by short-term debts. Businesses end up eroding their long-term capital that should have been used for bigger investments to increase their returns. To mitigate this impact on change in working capital, businesses must ensure a level of working capital that supports both financial strength and surplus to leverage investment opportunities.

Is Negative Working Capital Good or Bad? 

While the word “negative” tied to the phrase has an adverse implication, negative working capital is not necessarily bad. It depends on various factors like the nature of the business operations, the industry, the cash flow position, the underlying causes of reduced working capital, and so on. 

When is negative working capital good? 

Negative working capital often means a business is efficient enough to turn its inventories into a cash flow influx in a short period of time. It also outlines its strength in securing funds from creditors while simultaneously ensuring consistent revenues and timely payments from customers. 

However, to ensure negative working capital remains a good sign, a business must have a prompt revenue stream and a strong cash flow strategy. They have to make sure it doesn’t turn into a red flag by maintaining good relationships with suppliers and ensuring operational efficiency. 

When is negative working capital bad? 

Negative working capital becomes a bad sign when a business is unable to meet its operational expenses or settle its short-term financial obligations. Even if a business uses negative working capital without issues, a single speed breaker in sales can hurt operations in no time. 

Additionally, if a business loses its inventory due to wastage, fire, theft, , or any other reason, it reduces the value of stock on the balance sheet, resulting in negative working capital. Further, this makes it difficult for a business to meet its operating expenses and cater to customer demands. 

Moreover, negative working capital that occurs because of selling goods at a lower price eventually leads to reduced profitability along with a downward trajectory in financial performance.

Impact of negative working capital on cash flow

Negative working capital often creates surplus cash flow, as it means a business is financing its business operations with short-term debts like accounts payable, trade credit, etc. This, coupled with a higher inventory ratio and delayed payments to suppliers, helps businesses operate with negative working capital, not tying too much cash while ensuring a source of funding for daily operations.

 While negative working capital can help businesses improve their cash flow by reducing external financing, businesses must be careful about cash flow management and relationships with vendors. Any damage to creditworthiness will not only hamper the debt relationship with suppliers but also make it difficult to garner finance in the future. 

What Is The Easiest Way To Track Positive And Negative Working Capital? 

To ensure effective optimization of working capital, businesses must track working capital regularly by monitoring and examining financial statements, especially balance sheets. Here’s how to do it. 

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  Monitor current assets

  
  

  Track current assets by totaling all the short-term assets. This includes account receivables, inventory, cash and cash equivalents, and any other assets that businesses can convert into cash in a short period of time.

  
  
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  Compute your current liabilities

  
  

  Add all the current liabilities, like accounts payable, short-term debts, accrued expenses, and any other liabilities outstanding in the year.

  
  
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  Compute working capital

  
  

  Now deduct current liabilities from current assets and analyze the resultant figures. If it’s positive, it means the business has positive working capital and will be able to meet its short-term obligations using available resources. If it’s negative, then the business has to evaluate the underlying causes and find out if it’s a good sign with a higher inventory turnover ratio or a bad one with lower cash reserves and more accounts payable. 

  
  
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  Consistent reviewing and updating 

  
  

  Businesses must keep tracking and reviewing changes in current assets and liabilities from time to time to identify major fluctuations in working capital. This can be done on a weekly, monthly, quarterly, or half-yearly basis to keep abreast of their financial performance.

  
  

How To Avoid Negative Working Capital?

The key to avoiding negative working capital is to have robust working capital management in place. Here are a few techniques that can help businesses ensure working capital effectiveness. 

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  Accelerating account receivables collections 

  
  

  Account receivables refer to the money due from customers, and businesses are yet to collect them. Outstanding invoices turn into revenues only when customers pay for their purchases. Streamlining and optimizing accounts receivable processes will not only help expedite cash inflows but also result in improved working capital. 

  
  

  Moreover, businesses can automate AR processes that can reduce human error, increase invoice accuracy, and make sure that payment reminders are sent on time. Businesses should define clear AR policies and ensure easy access to customer data through a centralized vendor management dashboard to increase collections. 

  
  
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  Streamline accounts payable outflows 

  
  

  Another beneficial technique is to negotiate with vendors and optimize the release of accounts payable. Businesses can automate the AP processes and gain holistic visibility over outstanding payments. Based on this, businesses can establish improved transparency and communication and offer better payment terms. The key would be to maximize the payment period so businesses can utilize the cash flow from inventory sales. 

  
  
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  Efficient inventory management 

  
  

  Most of the working capital problems arise due to inventory issues. If businesses keep too much-unsold inventory on the floor, it ties up working capital and shortens the cash conversion cycle. Businesses would also need to improve cash conversion cycles so they can save working capital for urgent business needs. 

  
  
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  Use invoice factoring 

  
  

  One more way to ensure timely invoice payments from customers is to use invoice factoring. It helps businesses sell unpaid invoices for cash to a factoring agency and get advances up to 90% of the invoice’s value. Once the agency receives payments from default customers, the business will get the remaining invoice value after deducting factoring fees. This will also eliminate the process of tracking down payments. 

  
  
  
  

  Streamline your invoice collection with our thoughtfully-curated 

  
  

  Invoice Collection Email Templates

  
  
  
  
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  Ensure accurate cash forecasting 

  
  

  Cash flow forecasting will enable businesses to project, examine, and address the underlying causes of negative working capital. Businesses must be able to identify trends, seasonal fluctuations, or market variations to make informed debt/investment decisions. This will help maximize the efficiency of working capital while minimizing risks in the long run. 

  
  

  In addition, businesses can implement short-term forecasts to streamline short-term liquidity planning and monitor daily cash flows. It will also help make smarter borrowing decisions while saving working capital during high volatility periods. 

  
  

  

  
  
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  Streamline cash flow management 

  
  

  Effective cash flow management is a critical step to ensure efficient working capital and limit unnecessary expenses. Businesses can monitor their cash flows to analyze cash position and gain a holistic real-time view of their cash to ensure optimized cash flow. Second, they must ensure effective cash flow planning to adjust current budgets and allocate cash flows to ensure adequate working capital at hand. 

  
  
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  Efficient debt management 

  
  

  Efficient debt management practices can reduce the long-term effects of debt payments on working capital while reducing the overall cost of borrowing. These include negotiating for better interest rates, timely repayments, and creating and tracking debt deals through centralized locations using automation. 

  
  

How Can HighRadius Help Businesses Transform Working Capital Management? 

To ensure effective working capital management, businesses need a robust cash flow management and cash forecasting system in place. HighRadius brings cutting-edge cash management and cash forecasting software to redefine the way businesses manage their working capital. These automated solutions from our treasury suite will help businesses view, manage, analyze, forecast, and get complete control over their working capital without any hassle. 

The automated cash management solution helps businesses ensure complete visibility over their cash and bank balances. Second is our automated cash forecasting solutions, which help businesses consolidate projections and also allow collaboration across multiple business functions and hierarchies.

Moreover, solutions like AI-based AR and AP forecasting features will help businesses keep track of expected cash flows from customers while maintaining favorable payment terms with suppliers, thereby improving working capital levels. Businesses can also create what-if scenarios to detect the scope of negative working capital in the long run and analyze the impact of each scenario on cash flows using our features like scenario builders and forecast snapshot comparison. 

The results? Increased business forecasting productivity by 70%, along with 95% forecast accuracy.

FAQs

1) What types of companies typically have negative working capital? 

Businesses like fast food restaurants, software and telecom companies, utilities, omnichannel retailers, etc., usually have negative working capital. For instance, Apple has a negative working capital of $-45.915 billion. But since upfront payments from customers get reinvested, it is not a bad sign. 

2) What could be the impact of negative working capital on a company’s valuation?

A negative working capital creates surplus cash for a growing company, but it would require cash investments if the business started to decline. It can drive higher valuations as it is often viewed as an efficient business model where a company runs well even with a minimum working capital. 

3) Can net working capital be negative? 

Yes, a company’s net working capital can be negative. This occurs when its current liabilities exceed its current assets. Negative net working capital can also arise due to making significant purchases for equipment, increasing inventory levels, or other investment activities, etc.

4) Can the working capital turnover ratio be negative?

Yes, the working capital turnover ratio can be negative. It occurs when a business has more current liabilities than current assets. It shows that a business’s short-term obligations exceed the current assets available. It is computed by dividing the net sales of a business by its working capital. 

5) What is zero working capital?

When a business’s current assets are exactly equal to its current liabilities, then it is called a zero working capital situation. This happens when a company’s current liabilities completely fund its current assets. Zero working capital can increase the effectiveness of a business’s investment.

6) What is a good working capital?

The current ratio or working capital ratio is calculated by dividing current assets by current liabilities. A working capital ratio of between 1.5 to 2 is usually considered to be a good working capital ratio. It indicates a company’s financial resilience and robust liquidity position.