Let us look at the creation and maintenance of Net Working Capital with the help of Operating Cycle of a Company.

Starting the cycle,
Step 1: Creditors extend goods on credit by $1000, NWC = 0.
Liabilities Side: Accounts Payables created by $1000
Asset Side: Inventory of Goods Created by $1000

Step 2: Inventories worth $500 sold to Accounts Receivables 20% margin for $600, NWC = +100.

Liabilities Side: Accounts Payables created by $1000
Asset Side: Inventory of Goods Created by $500 ($1000-$500)
Asset Side: Accounts Receivable created by $600

Step 3: Accounts Receivables paid Cash $400, NWC = +100.

Liabilities Side: Accounts Payables created by $1000
Asset Side: Inventory of Goods stands at $500
Asset Side: Accounts Receivable Reduced to $200 ($600 – $400)
Buy Try Buttons Show Buyer Purchase DecisionAsset Side: Cash created by $400

Step 4: Accounts Payable are paid $300. NWC = +100.
Liabilities Side: Accounts Payables reduced to $700 ($1000-$300)
Asset Side: Inventory of Goods Created by $500
Asset Side: Accounts Receivable Reduced to $200
Asset Side: Cash reduced by $100 ($400-$300)

We noticed that if the same cycle carries on, with every new cycle, the current assets will keep on increasing because of the addition of margin while transferring the goods from accounts payable to accounts receivable. Therefore, in a normal situation, working capital will not go negative. It will always remain positive.

For working capital to go negative current assets must go below the current liabilities.

Situation for Negative Working Capital

Abnormal Loss in Inventory

If there is a loss in inventory due to wastage of material, fire in the store, theft, etc or any such reason which will diminish the value of inventory in the balance sheet will result in negative working capital. If the goods are lying in store for long and company is not able to sell, the value will deteriorate.

Bad Debts

If a company faces a lot of bad debts, it can lead to NeWC. It may be because of bad selection of customers, credit extension to customers with bad credit records, excessively aggressive selling approach etc.

Goods Sold at Loss Consistently

We saw above that the value of current assets is more than current liabilities due to margins added in between and if we are selling at a negative margin, it will take current assets below the current liabilities.

Cash Used for Investing in Fixed Assets

If the normal operating cycle continues for long, a company becomes cash rich. Above all, if the credit period allowed by accounts payable i.e. 30 days is more than the period it takes to complete the remaining cycle (Inventory >> Accounts Receivables >> Cash), the company will become super cash rich.

Another far end example could be taking goods on credit of 30 days and selling them in cash within 10 days will create such a situation. This cash is partly utilized by such companies to invest in their fixed assets or long-term investments. This will make their working capital negative but still a smooth operating cycle.

Is Negative Working Capital Good or Bad?

Now, we are in a position to comment on whether negative working capital is good or bad. The answer is obvious that it will depend upon the reason due to which it is going negative. If the reason for NWC going negative is abnormal inventory loss or high level of bad debts or consistently selling goods at loss. Yes, the negative working capital is a bad sign and company has all the probabilities of facing financial distress or even bankruptcy. If the reason is an investment of extra available cash in Fixed Assets or Long Term Investments without disturbing the operating cycle of the company, the negative working capital is a sign of efficient management. Such situations appear for giant companies having muscle power of bulk demand and who can command credit terms with the suppliers. Also, companies having cash sales but credit purchase are able to create such a situation. 

Last updated on : August 31st, 2017
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About The Author

Sanjay Bulaki Borad
Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of training100.ru. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".


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