Negative working capital is when a company’s current liabilities are greater than its current assets. Current liabilities are those that are due in less than 12 months. Current assets are those that can turn into cash in less than 12 months.
It’s easy to think that companies with negative net working capital would be at financial risk, but that’s not necessarily the case. There are many situations where having occasional and controlled negative working capital can actually work in a business’s favor.
Read on for an in-depth look at what it means to have negative working capital, when it can happen, and whether it’s a good or bad thing for your small business.
Key Points
• Negative working capital occurs when a company’s current liabilities exceed its current assets, indicating potential cash flow challenges.
• Businesses like supermarkets and restaurants often have negative working capital due to fast inventory turnover and delayed payments to suppliers.
• Negative working capital can, however, signal a risk of not meeting short-term obligations, potentially leading to financial strain.
• Some companies use negative working capital strategically to free up cash by delaying payments to suppliers.
• If your small business is struggling with working capital, you can take out a working capital loan or business line of credit to help meet short-term obligations.
What Is Negative Working Capital?
Working capital is the difference between a business’s current assets and current liabilities.
Working Capital = Current Assets – Current Liabilities
A current asset is an asset that can be easily converted to cash within a year. Current assets include cash, cash equivalents, accounts receivable, stock inventory, marketable securities, prepaid liabilities, and other liquid assets. A current liability is any debt that is expected to be repaid within a year. Current liabilities include obligations such as accounts payable and amounts due to suppliers, employee wages, and payroll tax withholding.
Ideally, current assets should be greater than current liabilities but for many businesses, that’s not always the case.
Negative working capital is when a company’s current liabilities are greater than its current assets, as stated on the firm’s balance sheet. While that may sound like a risky proposition, some businesses are able to dip into periods of negative working capital without any ill effects.
Negative working capital commonly arises when a business generates cash very quickly because it can sell products to its customers before it has to pay the bills to its vendors for the original goods or raw materials. It then uses that cash to purchase more inventory or expedite growth in other ways. By doing this, the company is effectively using the vendor’s money as an interest-free loan. The firm still has an outstanding liability, however, which means it can end up with negative working capital.
Positive Working Capital
Positive working capital is when a company’s current assets exceed its current liabilities. It’s the opposite of negative working capital and is usually a good position for a company to be in. Positive working capital means your business will be able to fulfill its financial obligations in the coming year and still have cash leftover to deal with any market disruptions (or other challenges) and/or invest in growth.
In order to be approved for a small business loan, businesses usually need to have a positive working capital, since many loans require assets as collateral. If the business is upside down on its debts vs. its assets, it may have trouble getting approved. However, working capital is one of many factors that lenders look at when approving loans.
Is it possible to have too much positive working capital? Yes. If assets are sitting somewhere and not helping the business grow and generate further revenue, then it’s possible they could be better used elsewhere to fuel the company’s next phase of development. To be competitive in today’s market, leveraging growth for healthy, steady business expansion is often essential.
Zero Working Capital
Zero working capital is when a company’s current assets are the same amount as its current liabilities. Having zero working capital can be a good sign, suggesting that the company is managing its resources effectively, maintaining just enough liquidity to cover its short-term obligations without tying up excess capital in non-productive assets.
However, having zero working capital can also signify that the company is operating on thin margins and doesn’t have much room for error. If unexpected expenses arise or if there’s a downturn in sales, the company could face liquidity problems.
Sometimes, a company might intentionally maintain zero working capital for a short period, perhaps to finance a specific project or investment. However, this is typically not a sustainable long-term strategy.
How to Calculate Negative Working Capital
Negative working capital is calculated by subtracting current liabilities from current assets. If liabilities exceed assets, the result is negative working capital. The formula is the same as the formula for working capital, with the end result being negative:
Negative Working Capital = Current Assets – Current Liabilities
Here’s a negative working capital example:
A gaming retailer buys $1.5 million worth of the latest console directly from the manufacturer. It sells every console within the first day, but doesn’t have to pay its bill for the next 45 days. So it uses this influx of cash to buy more consoles and further increase revenues. In this case, negative working capital works because sales are growing. As a result, this retailer should not have trouble meeting its short-term financial obligations as they become due.
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How Negative Working Capital Arises
While negative working capital might seem alarming, there are situations where it can be a strategic choice or a temporary condition. Here’s a look at some reasons why a company might have negative working capital.
• Industry norms: Some industries naturally operate with negative working capital due to their business models. For example, retail businesses often collect cash from customers before paying suppliers for inventory. This allows them to operate with negative working capital, using suppliers’ credit to finance their operations.
• Rapid growth: A company experiencing rapid growth might have negative working capital because it’s investing heavily in inventory and receivables to support increased sales. While this can strain short-term liquidity, it’s often seen as a sign of expansion and can be managed if the growth trajectory is sustainable.
• Seasonal variation: Businesses that experience seasonal fluctuations in sales may have negative working capital during slow periods when they build up inventory and receivables in anticipation of higher demand.
• Efficiency goals: In some cases, companies deliberately manage their working capital to optimize efficiency. They may prioritize cash flow by delaying payments to suppliers or accelerating the collection of receivables, even if it results in negative working capital on their balance sheet.
When Is Negative Working Capital Good vs Bad?
As mentioned, negative working capital can either be good or bad. Let’s take a closer look at why.
Good Negative Working Capital
Negative working capital can be a good thing when companies are able to sell their inventory faster than their suppliers expect payment. This cash surplus allows the company to purchase more inventory or spur growth in other ways. In this scenario, the vendor is essentially financing part of the company’s operating and investment expenses — similar to a zero-interest loan.
Negative working capital can also provide a company with greater flexibility and agility to respond to changing market conditions or unexpected expenses, while also allowing it to take advantage of growth opportunities as they arise.
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Bad Negative Working Capital
As soon as a company is unable to pay its operational costs or suppliers on time, negative working capital can shift from good to bad. Even if a company may have utilized negative working capital in the past without issues, a hiccup in sales can hurt operations fast. Negative working capital leaves a company with minimal cushion to absorb the unexpected.
If a business must constantly delay payments to vendors and suppliers, it could strain relationships with those partners. Over time, suppliers may become reluctant to extend credit or offer favorable terms, which could affect a company’s ability to secure necessary goods and services.
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Which Industries Typically Have Higher Negative Capital?
Companies with rapid turnover of inventory or services and make their money through cash often have negative working capital. This includes large food stores, retailers, fast food restaurants, service-oriented business, e-commerce companies, and software companies.
Strategies for Dealing With Negative Working Capital
To stay on top of negative working capital, business owners may want to:
1. Fully understand the flow of cash within your company. Using a business balance sheet to track income and expenses can help you pinpoint money issues that could contribute to negative working capital.
2. Keep track of account receivables.
3. Analyze how long it takes to completely sell through inventory batches.
4. Optimize billing cycles to space out expenses to match estimated sales.
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The Takeaway
Negative working capital is a state in which a company’s current liabilities exceed its current assets. Negative net working capital is fine as long as a company is able to pay its operational expenses and suppliers on time. If it is unable to do so, however, its long-term financial health may be in jeopardy.
While negative working capital can offer certain advantages in terms of cash flow management and flexibility, it’s essential for companies to carefully monitor and manage their working capital levels to avoid potential pitfalls and maintain financial stability.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What does negative working capital indicate?
Negative working capital can indicate a business has a high inventory turnover, meaning it’s able to sell off inventory before any amount is owed to the supplier. On the other hand, it can also mean that the business is having difficulty receiving on-time payments from its customers.
Is negative working capital typically a bad thing to have?
Not necessarily. Businesses in retail or fast-moving consumer goods often operate with negative working capital because they receive payment from customers before paying their suppliers. However, negative working capital can also signify liquidity issues, financial distress, or strained supplier relationships if the company is unable to meet its short-term obligations.
Can working capital being too high be a problem?
Yes. High working capital often means that a significant portion of the company’s assets is tied up in short-term assets like cash, accounts receivable, and inventory. If these assets are not being efficiently utilized, it can lead to lower returns on investment and reduced profitability.
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