What is Negative Working Capital?

Working capital is the money used by a company to fuel its short-term or day-to-day liabilities. Typically, it’s calculated as current assets minus any liabilities. Negative working capital is when the result of this equation is negative, meaning that the liabilities are greater than the assets in the short-term, day-to-day operations. To laymen in the business world, this probably seems like a terrible scenario.

However, as with many things in this world, it’s not always that simple.

Negative working capital, when used properly, can be an asset to companies trying to reach the best possible “working capital efficiency.” In fact, many industries, particularly the retail and telecom sectors, have successfully employed a negative working capital strategy to realize maximum gains for their business and shareholders.

In its most basic form, working capital — also known as “net current assets” or “net working capital” — is an equation of assets minus liabilities.

The result of this equation is either positive working capital, negative working capital, or zero working capital.

Positive working capital is when a company’s assets are worth more than its liabilities. This seems good on the surface because the company can pay all its bills in the short term with its current assets. However, this can be a drawback in many cases, particularly in retail.

For instance, one possible explanation for positive working capital is that the company has too much inventory that is not being sold or used. Although the assets (inventory) are greater than the liabilities (debts), assets being stuck in inventory means less efficient working capital. This phenomenon of unsold inventory is also referred to as “trapped liquidity.”

Some experts believe that zero working capital is the peak of working capital efficiency. If the accounts receivable equal the accounts payable, the working capital equates to zero. This typically means the company is not taking on excessive debt to help fund its working capital.

This might seem like the most efficient form of working capital, but it can have its own downsides. For instance, a company with zero working capital is more vulnerable to economic shocks. If inventory suddenly stops selling, short-term liabilities will become far more difficult to pay off.

Negative working capital is when a company’s liabilities are greater than its assets. There are multiple interpretations of how negative net working capital can affect a business.

If negative working capital arises in the short term, that can be a sign that the company has bought a large amount of inventory in response to an increase in sales.

However, if the company maintains negative working capital in the long term, it could be a sign of more fundamental financial issues.

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A company might change its capital strategy based on the trajectory of its business. For example, imagine a company has an idea for a new product that would require a substantial investment. In this case, management might want to keep more capital free to invest in this product. Once the investment is fulfilled, the company may then shift to a strategy geared toward negative working capital to increase efficiency.

One real-life example of a business changing its capital strategy over time is McDonald’s. The company had negative working capital in 1999; these days, however, it maintains a positive working capital cycle.

Ideally, a company quickly generates negative working capital because it’s good at selling. It orders huge amounts of inventory, thus increasing its accounts payable, and then rapidly sells that inventory.

As the business generates cash, it orders even more inventory before paying the accounts payable, resulting in negative working capital.

Telecommunications firms are an example of an industry in which negative working capital is standard. This is because telecom companies need to pay a large proportion of their costs at the beginning of the year, which consistently leaves them with more liabilities than assets.

It might seem unusual for telecom companies to have negative working capital if they don’t manufacture products, but expenses such as license fees, spectrum costs, and tower installations require a huge amount of capital.

That being said, negative working capital does not mean such companies are bad investments. High growth rates mean these companies can ask for larger credit periods while they work to expand their user base, eventually allowing them to pay off liabilities. It’s worth noting that this working capital cycle is unique to telecom companies and thus is difficult to compare to other industries.

Negative working capital also has its downsides. For one, it doesn’t allow much room for maneuvering should current liabilities greatly exceed current assets. If a company goes into too much debt, it risks bankruptcy.

Furthermore, a business with negative net working capital may be downgraded by independent debt analysts, making it more difficult to borrow money at lower interest rates. This can trigger a cycle in which higher interest rates increase current liabilities, pushing the company further toward unsustainability.

Negative working capital can also pose an obstacle to companies looking to invest in R&D or growth opportunities. After all, a company needs assets to fund its growth strategy.

In December 2020 and January 2021, the working capital marketplace CF20 surveyed more than 6,700 small and medium enterprises and asked them about their working capital requirements. The survey found a sharp increase in the costs of financing working capital post–Covid-19, compared to pre-pandemic years. This was due to interruptions in supply chains that were using an approach called JIT, or “just in time.

The JIT business strategy was pioneered in 1980s Japan. The strategy involves keeping inventory and trapped liquidity low and negative working capital high, with the goal of making capital more efficient by not wasting money on excess inventory. This allows companies to take money that would otherwise be tied up in inventory and invest it elsewhere in the business.

However, as the COVID-19 pandemic proved, a supply chain disruption can immensely strain this JIT strategy. For instance, imagine you were a company selling computerized toys. A chip shortage would mean you couldn’t manufacture and sell the final product, leading to a delay in your accounts receivable. If you maintain a consistent negative working capital balance sheet, you probably have other people in the supply chain extending credit to you, so your accounts payable payments would also be delayed. As you can see, a single disruption can impact the entire supply chain and cause problems for everyone involved.

If working capital is negative, it means a company’s short-term liabilities are greater than its assets.

Any working capital can be good if a company uses it efficiently. Companies with efficient working capital, even if they maintain a negative balance in the short term, are considered good investments.

One example of standard negative working capital is telecom companies. They spend a significant amount of their money upfront for expenses such as tower installations and licensing fees. Thus, they consistently maintain negative working capital at the beginning of the year.

Both negative and positive working capital can be good for a business. What matters is if the company uses its working capital efficiently.