Why is Working Capital Negative? (Explanation With Example)

Introduction:

Working capital is the amount of a company’s current assets less current liabilities. This capital of a business is required to fulfill the daily trading operation of a business. Net working capital is normally positive when total current liabilities are less than total current assets.

Negative working capital occurs when the current liabilities exceed the current assets. Negative working capital could mean that the entity does not have enough quick or liquid assets like cash or other assets that could quickly convert into cash to settle current liabilities.

Explanation

Working capital is a measure of operational efficiency, it is used to interpret how many current assets such as cash, amounts receivable from debtors and inventory will be able to liquidate in a year to set off the current liabilities.

Usually, negative working capital in a company’s balance sheet is not encouraged as the suppliers and the other creditor may feel reluctant to offer their goods and services on credit to the company, doubting its ability to pay back timely.

Following is the calculation of negative working capital.

Example

Company XYZ

Extract from Balance Sheet

Current AssetsUS$Current LiabilitiesUS$
Inventories150,000Trade Payables 180,000
Trade Receivables45,000Accrued Expenses15,000
Bank2,000Current Portion of Long-term Debt5,000
Total 197,000Total200,000

Current Assets – Current Liabilities = Working Capital

$197,000 – $200,000 = ($3000)

If the negative working capital is only temporary it can be because of a huge cash outlay for investments in growth opportunities, purchase of fixed assets, or a substantial order of goods on credit from the vendors to meet the excessive demand of the customers in the market.

A temporary negative figure is not an alarming situation as it is probable that there will be greater returns from the investment in the near future and that catering to an increase in demand will result in sales growth causing a significant increase in the accounts receivables.

However, negative working capital will be a cause of concern if it occurs for an extended period of time, this can happen when there is a decrease in the demand for the product and the inventory turnover is low which results in the obsolescence of inventory leading to a deterioration in the net realizable value of the inventory or when there is an abnormal loss in the value of the inventory through theft or destruction.

Related article  What is Working Capital in Financial Management? (Concept and Objective)

Furthermore, negative working capital can be caused by the inability of the company’s debtors to make timely payments or not being able to pay within the prescribed credit period, the company then will have to record bad debts and provisions which will reduce the current assets.

This situation can arise when a company’s credit policy is not appropriately drafted and it has extended credit to customers with not an adequate credit scores.

Therefore, negative working capital is not always a matter of concern, it depends upon the reason causing it if it is due to bad debts and continuous losses the management should then take steps to correct it as it will cause financial distress but if it is due to investments then it represents the efficiency of the management to prosper.

It can be reasoned that working capital is actually an indicator of the company’s efficiency in its operational activities which is why the working capital changes over time.

Suppose a company has excess current assets as compared to its current liabilities. In that case, this shows a conservative behavior toward finance, and too many resources are tied up and left idle, which means they are not being utilized for earning more profits.

While a negative or zero working capital may illustrate that the management is trying to utilize every fund in different projects which will generate income in the foreseeable future.

Contrariwise, it can also be seen as little working capital devoted to daily operations and an aggressive approach to finances.

10 Reasons that Cause Negative Working Capital

Negative working capital is where current liabilities exceed current assets, leading to cash flow problems and potential insolvency. Here are the top 10 causes of negative working capital:

  1. High inventory and slow turnover: Low turnover leads to a build-up of stock that ties up cash which could be used for other things.
  2. Slow customer payments: Customers take longer to pay their bills, resulting in extended payment terms that consume available cash.
  3. Poor inventory management: If invoices and orders aren’t appropriately managed, it can cause delays in ordering from suppliers or excess stock left unsold.
  4. Too much reliance on debtors/suppliers: Companies are at the mercy of their lenders and creditors when terms become too lenient – tying up valuable working capital in non-productive areas.
  5. Increased operating costs: Higher expenses due to labor, materials, or equipment tie up cash flow which would otherwise be used to cover operational overheads.
  6. Unnecessary accounts payable balances: Keeping more funds than necessary tied up in accounts payable leaves a company with more available resources during peak periods.
  7. Cash siphoned off by owners/shareholders in dividends or remuneration packages: Company funds can be redirected away from operations into shareholders’ pockets if not monitored closely enough – leaving less money for productive activities or settling debts on time. 
  8. Weak credit vetting processes: Selling goods or services to customers without proper checks can lead to bad debts and tying up resources until payment has been received in full (if at all). 
  9. Inaccurate sales forecasts & pricing models: Incorrect estimates of future demand can lead to overstocking and an inability to capture market opportunities due to inadequate cash reserves. 
  10. Lack of financial planning & control processes: Without clear objectives or guidelines, it is difficult for businesses to manage their finances efficiently or establish reliable sources of short-term credit when needed most.
Related article  What is the Concept of Working Capital? (Gross Working Capital and Net Working Capital)

10 Tips On How to Improve Working Capital

Here are ten tips on how to improve working capital:

  1. Review and analyze all current accounts receivable: Identity which customers are taking longer than usual to pay and take action if needed.
  2. Negotiate payment terms with suppliers: Get favorable terms that reduce costs, improve supplier relationships, and provide greater control over cash flow.
  3. Optimize inventory management processes: Reduce ordering costs, identify the slow-moving stock, and adjust prices for excess goods where necessary.
  4. Shorten cycle time from customer order to product shipment: Speed up the process from receiving customer orders to shipping products in order to reduce working capital requirements.
  5. Introduce customer incentives for early payments: Offer discounts or extended credit periods in exchange for faster payments – this will help raise cash more quickly while reducing the need to borrow funds from a lending institution.
  6. Rethink pricing models: Analyze your pricing strategy and determine whether higher prices could be charged at certain times of the year – raising potential profits while also reducing working capital requirements by generating more upfront cash flow.
  7. Take advantage of government subsidies: Explore options such as grants, tax incentives, and other programs which may reduce operating costs and free up valuable funds for other activities such as debt repayment or building inventories/stockpiles of raw materials/goods in need of replenishment periodically throughout the year. 
  8. Monitor accounts receivable regularly: Closely monitor invoices due from customers and ensure they are being paid on time – late payments can have a serious impact on cash flow and the overall solvency of a business entity.
  9. Investigate alternative financing options: Consider unconventional financing methods such as invoice factoring or customer discounting in order to access needed funds without relying too heavily on banks or other traditional lenders.
  10. Anticipate seasonal trends & plan accordingly: Historical sales data should be used to predict seasonal peaks (and troughs) accurately so that businesses can adjust their operational strategies accordingly – e.g., stocking up on goods before demand increases sharply, thereby reducing the need for emergency purchases later on.
Related article  Working Capital Ultimate Guide: Definition, Calculation, Example, and More

How does the Negative Working Capital Affect the Company?

Negative working capital can have a severe impact on companies in several ways, including:

  1. Reduced Cash Flow: When current liabilities exceed current assets, businesses struggle to pay for necessary expenses, resulting in cash flow problems. This can lead to late payments to suppliers and creditors, which has a domino effect on other business dealings, such as hiring new staff or obtaining additional financing when needed.
  2. Inability to Take Advantage of Opportunities: Negative working capital stifles company growth by preventing investments in new projects and initiatives – particularly those which require upfront payments or significant resources to implement. Without sufficient liquid resources available, companies cannot seize potential opportunities as they come along.
  3. Increased Risk of Insolvency: The longer negative working capital persists, the higher the likelihood of insolvency or bankruptcy due to insufficient funds to cover operational expenses and settling debts in full (when due). Companies operating under such circumstances will need external assistance through loans or alternative funding sources to stay competitive with their rivals and meet customer demands.