Negative Working Capital: Definition & Meaning for Business

As a business owner, have you ever spent cash from sales before paying your suppliers? It seems risky, right? Because this means your current liabilities exceed your current assets. This is what negative working capital means.

While it may seem counterintuitive, negative working capital isn’t always a sign of financial distress. In some cases, business owners deliberately maintain negative working capital as part of their financial strategy.

In this article, our goal is to give you a clear understanding of what negative working capital means and help you navigate its complexities. You will learn about the pros, cons, and significant effects it can have on a business.

What is negative working capital?

Negative working capital occurs when the current liabilities of a business are higher than its current assets and income. It indicates that a business is required to pay more for its short-term financial obligations than what it has available as assets.

While no business wants to get into a situation where it doesn’t have enough working capital to pay bills or disburse salaries to its staff, it’s not a risky situation for every business. Businesses may find themselves in a state of negative working capital when they make a lump sum investment, either in stocks, equipment, or new products.

Certain businesses or sectors experience negative working capital but are not impacted much. For example, grocery stores, retailers, restaurants, and fast-moving consumer goods (FMCGs) may have negative working capital, but it isn’t a significant risk for them.

To gauge a company’s working capital status, the Working Capital (WC) formula comes into play. It’s calculated by subtracting current liabilities from current assets:

Working Capital (WC) = Current Assets − Current Liabilities

For a more detailed understanding of this calculation, refer to the blog article: Understanding Changes in Working Capital Formula

Understanding these financial metrics is pivotal for businesses looking to manage their working capital effectively.

Understanding the working capital cycle

The working capital cycle is the time required by a business to liquify its current assets. Business owners need to have a clear understanding of this concept because it would help them track their cash flow.

There are four phases in a working capital cycle:

1. Cash: First, the business has to make sure that there’s a healthy inflow/outflow of cash.
2. Receivables: Then, the business optimises customer payment terms and conditions or receivables.
3. Inventory: Tracking the time taken to sell off inventory is a crucial step.
4. Billing: Finally, the time taken to pay suppliers is an important step as well.

The working capital cycle formula is as follows:
Working Capital Cycle in Days = Inventory Days + Receivable Days – Payable Days

Let’s use fictitious examples to understand this better. 

Example of working capital cycle for a manufacturing company

Suppose ABC Limited manufactures furniture from timber and sells the finished products to retailers. It requires 45 days to procure raw materials and hold the timber for 18 days on average before using it for production. The time taken to manufacture the final product is 11 days on average. The holding period for finished goods is 28 days. Finally, customers who buy the products pay, on average, within 52 days. 

Working Capital Cycle in Days = Raw Materials Inventory Holding Period – Trade Payable Days + Work-in-Progress Holding Period + Finished Goods Holding Period + Trade Receivable Days 

18 – 45 + 11 + 28 + 52 = 64 Days 

From the above calculation, we understand that ABC Limited will have an average of 64 days between manufacturing and selling the product and receiving money from customers in its account.

The manufacturing company would have a shorter working capital cycle and a better cash flow if it extended its payable days. Negotiating credit terms with its suppliers is an effective way towards this step. 

Also read: Understanding Changes in Working Capital Formula

Decoding Negative Working Capital

When a company collects money at a quicker rate than the time it takes to pay bills, it’s known as a negative working capital cycle. A short working capital cycle has its benefits because it helps business owners use cash that would otherwise have been stuck in the cycle. A long operational cycle locks up crucial capital and doesn’t generate any significant return.

Negative working capital: Is it good or bad for my business?

What does negative working capital truly imply? Let’s first understand the good and bad causes of negative working capital in a business: 

Good causes of negative working capital 

• Faster turnover of inventory due to increased customer demand 

• Efficient collection of accounts receivable from customers who made payments using credit 

• Delay in suppliers’ payments due to buyer’s power

Bad causes of negative working capital 

• Decrease in sales due to lower cash and credit purchases 

• Decrease in purchase of inventory to match the lack of customer demand 

• Insufficient funds which causes a delay in supplier or vendors’ payments 

The working capital structure of a company may change if there’s a change in policies. For example, while McDonald’s has a positive working capital now, it was not the case between 1999 and 2000. 

Moreover, Autozone, a famous auto retailer company had $155 million under negative working capital. It adopted a strategy of efficient inventory turnover. It stopped investing in bulk inventory and sold off its goods as soon as possible. Thus, it freed up its capital in the process. 

While having a negative net working capital is not ideal, very high positive working capital may also not be a good idea. A high positive working capital indicates the company has many current assets and few liabilities. It means that the company is not making optimum use of its cash and cash equivalents. 

Will negative working capital impact my company valuation?

Negative working capital alone does not necessarily have a direct negative impact on a company’s valuation. Valuation is a complex process that involves considering various financial metrics, growth prospects, industry conditions, and risk factors.

However, businesses that have a negative working capital often find it challenging to pursue various opportunities for innovation, expansion, or acquiring competitors. This can also impact plans for growth, as investors interpreting negative working capital on the company balance sheet may look at it as poor sales performance or delayed customer payments.

Additionally, a lack of readily available funds can expose a business to vulnerabilities, with the potential need for immediate capital in scenarios such as repairs, legal expenses, or unforeseen financial downturns.

Effectively managing cash flow is a challenging task, particularly as month-end approaches and bills become due. With working capital loans, businesses gain a valuable resource. These loans offer the flexibility of accessing funds when needed, allowing for extended periods to address financial obligations and enhancing overall cash flow management.

Dealing with a negative working capital situation

Shortening the working capital cycle is an effective way to deal with a negative working capital situation. Here’s what you should do:

• Monitor working capital ratio: A decreasing working capital ratio (current assets + current liabilities) can indicate improved efficiency in managing working capital.
• Enhance inventory management: Practice just-in-time inventory systems to reduce excess stock and use advanced forecasting tools to predict demand accurately. Identify slow-moving items and consider discounting or other strategies to move them faster.
• Negotiate better credit terms with suppliers: Build string relationships with your suppliers and negotiate flexible payment terms. Seek discounts for early payments or explore consignment arrangements.
  
• Increase sales revenue: Introduce product bundles, promotions, or loyalty programs to attract new customers and engage the existing ones. Expand into new markets or channels to tap into additional revenue streams.
• Reduce unnecessary expenses: Identify and eliminate unnecessary costs by conducting  a thorough review of operational expenses.

Operating with a negative working capital might be a part of your business strategy, but when day-to-day operations demand immediate financing, a reliable credit solution becomes important. This is where Razorpay Working Capital Loans steps in, offering a financial cushion to businesses struggling with with cash flow challenges.

• Cover short-term credit needs: Whether it’s paying suppliers or covering unexpected expenses
• Seize growth opportunities: With timely financing, you can  invest in marketing, expand your product line, and more
• Maintain business continuity: Quick approval and disbursement ensure you have the funds to maintain operations without disruptions

Frequently asked questions

Q: Do e-commerce companies have a negative working capital?

Ans: Yes. Most e-commerce companies aim to maintain a negative working capital cycle. One popular example is Amazon. They don’t pay sellers right after a sale. Instead, the company follows a monthly or threshold-based payment schedule. This helps them hold onto their cash for longer periods, leading to a negative working capital. This approach allows them to finance their operations without paying interest through borrowing from suppliers.

Q: How do FMCG companies handle their working capital cycle?

Ans: FMCG companies often strive to maintain a positive working capital, meaning they receive payment from customers before paying their suppliers. For instance, a company like Procter & Gamble (P&G) is known for efficient working capital management. P&G typically operates with a positive working capital cycle, which means it receives payments from customers before it needs to pay its suppliers. However, it’s important to note that the industry is diverse, and different companies may adopt varying strategies based on factors such as market conditions, product characteristics, and overall business models.