Introduction:

Working capital is the amount of a company’s current assets less than the number of current liabilities; this capital of a business is required to fulfill the daily trading operation of a business. Networking capital is normally positive when total current liabilities less than total current assets.

And negative working capital occurs when the current liabilities exceed current assets. Negative working capital could mean that entity does not have enough quick 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 Assets $ Current Liabilities $
Inventories 150,000 Trade Payables 180,000
Trade Receivables 45,000 Accrued Expenses 15,000
Bank 2,000 Current portion of long term debt 5,000
Total 197,000 Total 200,000

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.

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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 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 of 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.

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 score.

Therefore, a 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 that is why the working capital changes overtime.

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

Whilst 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 the daily operations and an aggressive approach to the finances.