Working capital:

In accountancy, working capital is a measure of the ability of a company to pay off its short-term debts within a year or sooner. It reflects the liquidity of a company and can be calculated by deducting current liabilities from current assets as follows:

Net working capital = Current Assets – Current Liabilities

Current assets are assets which are expected to be sold, disposed or exhausted within a period of twelve months.

It includes accounts receivable, cash and cash equivalents, closing inventory, interest receivable, arrears etc.

Similarly current liabilities are short term debts that are expected to be paid off within a period of twelve months. It includes accounts payable, bank overdraft, interest payable, accruals etc.

Net working capital is often used by creditors to judge a customer before lending money to them.

It helps them understand whether a company is liquid enough to pay back within the specified time or is going to dodge payment deadlines.

Calculation of working capital:

Company ABC

Extract from Balance Sheet

Current Assets $ Current Liabilities $
Inventories 130,000 Trade Payables 175,000
Debtors 48,000 Accrued Expenses 20,000
Cash and bank 5,000 Current portion of long term debt 10,000
Total 185,000 Total 225,000

Net working capital = Current Assets – Current Liabilities

Net working capital = $185,000 – $225,000 = ($40,000)

Working capital can either be positive or negative. A positive working capital is an indication of a healthy financial system.

It signifies efficient accounts payable and accounts receivable processing by the company. Such companies can also be identified through a good receivable turnover ratio and payable turnover ratio.

A negative working capital occurs when the current liabilities exceed the current assets of the company.

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A negative working capital is an indication of poor management of cash flow and can occur due to abnormal damage to inventories or sale of goods at loss for a long period of time or a major debtor going bankrupt and you end up with a high bad debt balance.

However, a negative working capital is not always bad.

Why is negative working capital not necessarily bad?

If managed efficiently, a negative working balance doesn’t have to be bad. There are a few reasons why investors would consider a short term negative working capital a good sign and I’ll explain them below.

  • A working capital balance arises when the company collects cash up front and pays back the supplier with that cash immediately. Super markets and restaurants could be an example of such companies. It reflects efficient management of cash.
  • Similarly, a company can use the cash collected at point of sale to invest in the company rather than paying back the creditors. This would reduce accounts receivable and have no impact on accounts payable and would result in a reduction in working capital. However, it also suggests business growth hence; investors would be more likely to invest.
  • A negative working capital could also result from borrowing loan from a bank. However, it wouldn’t be considered bad if the loan has been obtained to invest in the company for example a plant or a new branch etc. The loan would increase the turnover of the company but would obviously be paid off yearly. Hence, the current maturity portion of bank loan would have a negative impact on working capital as well as the interest cost.
  • Companies that are subscription based or contract based also have a continuous negative working capital balance; even though the cash is collected, it hasn’t been earned which is why it is classified as an accrual. A subscription based company performs its obligations in the long-run even though the cash has already been collected and due to a high accrual balance it results in a continuous negative working capital balance at all times.