AS an investor while analysing the balance sheet you may have come across the term ‘negative working capital’ and often thought that as it is ‘negative’it is not good.
AS an investor while analysing the balance sheet you may have come across the term ‘negative working capital’ and often thought that as it is ‘negative’it is not good. However, this need not necessarily indicate a problem with the company; in some cases, it could be a good thing. Let us understand what is negative working capital and its relevance from an investor’s perspective.
Working capital is that part of capital which the company needs to run day-to-day operations such as paying wages, salaries, suppliers and creditors. In other words, it is excess of current assets over current liabilities. Current assets are those assets which can be converted into cash, normally within one operating cycle / one year. This includes assets such as cash and cash equivalent, debtors, inventory, prepaid expenses and other liquid assets which can be converted into cash easily. Similarly, current liabilities are those liabilities which are normally payable within one operating cycle / one year. This includes liabilities such as accounts payable, creditors, outstanding expenses, etc.
Negative working capital
Negative working capital arises in a scenario wherein the current liabilities exceed the current assets. In other words, there is more short-term debt than there are short-term assets. Generally, having anything negative is not good, but in case of working capital it could be good as a company with negative working capital funds its growth in sales by effectively borrowing from its suppliers and customers. Contrary to the above, some investors may think negative working capital is not good since a company is not able to pay its outstanding bills and creditors. When managed properly, negative working capital could be a way to fund your growth in sales with other people’s money.
How working capital becomes negative
Negative working capital often arises when a business generates cash so quickly that it can sell its products to the customer before it has to pay its bill to the supplier. In the meantime, it is technically using the supplier’s money to grow. Though it is good to have negative working capital, it is not everyone’s cup of tea. Generally, firms who are dealing with cash-only business enjoy high turnover with negative working capital. Such firms don’t supply goods on credit and constantly increase their sales. Online retailers, discount retailers, grocery stores, restaurants and telecom companies are expected to have negative working capital.
Is negative working capital good or bad?
It is not always bad to have negative working capital. It is by design that certain companies with established brands, apart from the industries mentioned above, have negative working capital because they are able to bargain very well with their suppliers. The major advantage is the holiday from bank financing; it saves the interest cost by getting the current assets financed by the suppliers. However, in the long term negative working capital could probably pose a problem. If a company always has more current liabilities than current assets its liquidity ratios may be not be lucrative. To conclude, working capital alone will not provide the long-term picture. As an investor, one needs to look at a company’s financial statements over the period of a few years with various other indicators apart from working capital.
The writer is professor, School of Commerce and Management, Central University of Tamil Nadu, Thiruvarur