Patrick Louie

When you’re operating a business, it’s important to be mindful of its liquidity.

By that, I mean that you want to ensure that the business has enough resources to pay for debts as they become due.

This usually means having positive working capital.

For working capital to be positive, the total current assets must be more than the total current liabilities.

As an example, let’s say that your business has total current assets of \$120,000 and total current liabilities of \$90,000.

Using the formula for calculating the working capital (working capital = current assets – current liabilities), we’ll arrive at \$30,000.

This means that your business has enough resources to pay for all of its current liabilities, while still having some extra.

So what if the total current liabilities are more than the total current assets?

Well obviously, it would result in negative working capital.

But what does having negative working capital mean for the business?

Is it automatically a bad thing?

Because, when you think about it, not having enough resources to pay for debts as they become due is an unfavorable situation.

It doesn’t present a good picture for creditors and potential investors, does it?

In this article, we will be exploring what negative working capital is.

How does it affect a business?

Is there a positive side to having negative working capital?

What causes negative working capital?

We will try to answer these questions as we go along with the article.

## What is Negative Working Capital?

When a business’s total current liabilities are more than its total current assets, it has negative working capital.

This means that it doesn’t have enough current resources to pay for all of its short-term liabilities.

It will have to raise additional capital just so it can pay for all of its short-term obligations.

But why is it called negative working capital?

To answer this question, let us take a look at the formula for calculating working capital:

Working Capital = Current Assets – Current Liabilities

As one can see from the formula above, having more current liabilities than current assets will result in a negative figure.

Hence, negative working capital.

For example, let’s say that your business has \$80,000 in total current assets and \$87,500 in total current liabilities.

Using the working capital formula:

Working Capital = Current Assets – Current Liabilities

= \$80,000 – \$87,500

= -\$7,500

We arrive at a working capital of -\$7,500.

This essentially means that your business has to raise at least \$7,500 additional capital just to be able to pay all of its current liabilities.

While a negative working capital doesn’t always have to be addressed immediately, one must always be aware of it as it can be an indicator of an upcoming bankruptcy.

And in the case of a potential merger or acquisition, a business would want to have positive working capital.

The acquiring company would want the target company to have enough liquid resources to meet all short-term obligations.

At a glance, having negative work capital can be a bad thing.

It doesn’t present a good picture to creditors and potential investors for a business to not have enough liquid assets to fully settle all short-term debts.

However, it isn’t always bad. In fact, it’s a common occurrence in certain industries.

## When Negative Working Capital isn’t a Bad Thing

When a business can reliably and consistently generate cash very quickly by selling its products before it has to pay its bills, it will probably have negative working capital.

For example, let’s say that a business has to pay one of its suppliers within 30 days.

However, it can reliably sell its inventory within 18 to 21 days.

This creates a situation where the business has fewer non-cash assets than its current liabilities, which technically results in negative working capital (to be more accurate, negative net working capital).

In such a case, the negative working capital is driven by operating efficiency.

This is a negative working capital situation that can generate excess cash flows.

It can also happen if the business is able to collect its receivables before having to pay its accounts payables.

We can also see this negative working capital situation as the business effectively using the supplier’s money for it to grow.

The business doesn’t always need to have enough cash to pay its suppliers because it can reliably collect enough before the debts become due.

However, this only works under the assumption that operations will stay as efficient as they are now (or more).

Should there be a time when there are delays in inventory turnover or accounts receivable collection, the business might face liquidity issues.

A business may also have enough leverage to extend its accounts payable terms with suppliers/vendors.

For example, a business may be able to negotiate a 60-day term, which allows for more opportunities for negative working capital situations.

The negative working capital strategy typically works for businesses that deal solely in cash and have a high inventory turnover.

These businesses typically have a relatively high volume of sales.

Examples of such businesses include the following:

• Retailers
• Grocery stores
• Restaurants
• Convenience stores

## Negative Working Capital as an Indicator of Bankruptcy

Operating efficiency isn’t the only driver of negative working capital.

Operating inefficiency may result in negative working capital too.

And it isn’t the good kind.

The lack of sales, inability to collect receivables, unable to sell inventory on time – all of these can result in negative working capital.

And unlike the case with operating efficiency, all these instances don’t produce profits.

Also, they don’t result in the generation of excess cash.

This might mean that the business really doesn’t have enough liquid resources to pay for all of its short-term debts.

If such a situation continues, the business will eventually face bankruptcy.

This is why a business has to be very careful before it implements a negative working capital strategy.

If it can’t generate enough cash flows to answer debts that are due, it might want to secure its liquidity first.

This is the type of negative working capital situation that businesses want to avoid.

One that isn’t strategic or intended at all. If a business continues to be in such a situation, its supplier and vendors might pull out their support.

It will also have a hard time convincing creditors to lend money, and investors to invest in it.

## Conclusion

Negative working capital doesn’t always mean that the business is in a tight spot.

Sometimes, it might be by design.

So long as the business is able to pay its debts on time, then negative working capital won’t lead to bankruptcy.

It’s advisable to analyze whether a business is suitable for a negative working capital strategy.

A good start would be to check if it solely deals in cash for its sales. Another area to check is its inventory turnover.

A high inventory turnover can indicate that the business has no problem generating cash in a timely manner.

Negative working capital is bad if it’s caused by operational inefficiency such as low sales, inability to collect receivables, low inventory turnover, etc.

Negative working capital caused by these instances may lead to bankruptcy if not addressed properly.

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1. Purdue University "Working Capital: What Is It And Do You Have Enough?" Page 1. August 25, 2022