What Is Negative Working Capital and Is It Good or Bad For My Business?

Last Updated November 21, 2024

When it comes to having a complete understanding of the financial health of your business, few metrics are more important to stay on top of than working capital. Small business owners in particular should regularly track working capital changes and monitor if they begin to experience consistent negative working capital.

But what is negative working capital, and can there actually be benefits to it?

Understanding what it means when you’re in a period of negative working capital will help you make sound financial decisions. Continue reading for an in-depth breakdown.

What Is Working Capital?

First, a quick recap on working capital. Working capital measures your business’s liquidity by subtracting current liabilities from current assets. By comparing assets and liabilities, you can determine if your company will be able to fulfill its financial obligations in the coming year and whether it can deal with market disruptions and other challenges.

How Do I Calculate Working Capital?

Fortunately, calculating your working capital is a straightforward process.

To measure your net working capital (or the amount of liquidity available to your business), add up your current short-term assets, which are your assets that could easily be liquidated, such as cash or inventory. This does not include fixed assets that are less liquid, such as buildings or machinery. Then subtract your current short-term liabilities, such as payroll taxes and accounts payable. This will give you a dollar amount of your net working capital.

Here is the working capital formula in more simple terms:

Working Capital = (Total Current Assets – Total Current Liabilities)

What Is Negative Working Capital?

With the formula for calculating working capital in mind, negative working capital describes any situation where the business’s current liabilities are greater than its current assets. So when calculating net working capital, you would have a negative number after subtracting liabilities from assets.

While the answer to “can working capital be negative?” is a yes, it’s important to understand why a business owner might find themself in this predicament. Though long-term negative working capital is a problem, a negative change in working capital is a common occurrence and shouldn’t set off any alarm bells.

Reasons for Negative Working Capital

There are several reasons why a company could experience negative working capital. In some industries, negative working capital is actually quite normal, while in others, it’s a sign of financial management issues. The following are some of the most common reasons why a business might see its current liabilities exceed current assets.

1. High Inventory Turnover

Negative working capital is actually quite common in industries that experience high inventory turnover. This includes businesses such as restaurants, grocery stores, and other retailers that don’t extend credit to buyers and have tight inventory control. The businesses collect money at a fast rate from their sales — typically faster than the timeline for repaying bills to their suppliers.

2. Large Purchases

Regardless of industry, it isn’t unusual for businesses to temporarily experience periods of negative working capital after making a large purchase. This could include buying new equipment or products or making other investments designed to fuel future growth.

3. Poor Invoicing

Many businesses struggle to have their own clients pay invoices on-time. Late payments or lengthy payment terms can create problems when the business needs to fulfill its own financial obligations before it has received payment.

4. Financial Struggles

For many businesses, poor financial management can lead to an ongoing cycle of negative working capital. These businesses might not be able to make ends meet, or they will turn to borrowing (incurring even more debt) to finance their operations.

Negative Working Capital Implications: Is It Good or Bad?

There’s not necessarily a one-size-fits-all answer to whether negative or low working capital is good or bad for a business. It ultimately comes down to the type of business in question and how it operates.

Companies with high inventory turnover like restaurants and grocery stores often operate in a negative working capital cycle. The quick cycle with which they sell their inventory can become a competitive advantage that allows them to invest in further expansion opportunities.

On the other hand, negative working capital could indicate that a business is in serious financial danger due to financial mismanagement.

Negative working capital could hurt the company’s valuation and make it harder to meet financial obligations.

Advantages of Negative Working Capital

So, how can negative working capital help a business — if at all?

Negative working capital is generally only an advantage for companies with high inventory turnover. When companies are able to sell the inventory faster than they need to pay their suppliers, it is almost like getting a loan from the supplier.

The cash that the company receives from its inventory sales can immediately be put to work to fund strategic growth opportunities. That cash could be used for business expansion, purchasing additional inventory, upgrading products and services, and more.

It’s important to keep in mind, however, that these advantages are generally limited to companies that are experiencing healthy cash flow from their inventory turnover, despite a negative working capital cycle.

Related: Working Capital vs. Cash Flow

Disadvantages of Negative Working Capital

While businesses with high inventory turnover may experience large influxes of cash, this generally isn’t the case for other types of businesses with negative working capital.

The impact of negative working capital often leaves businesses with insufficient liquid assets to cover their operational costs. This can get them in serious financial trouble, requiring that they turn to loans or other funding, like invoice factoring, to fulfill their liabilities. This leaves businesses particularly vulnerable to situations like unexpected market downturns or repairs that impact their budget and operations.

Negative working capital can also limit opportunities for expansion, as businesses won’t have enough available assets to finance growth or new innovations. Negative working capital can also scare off investors.

Without improvement, negative working capital could easily contribute to a company going out of business.

Tips for How to Improve Working Capital

Because negative working capital can present a real danger to a business, finding ways to improve working capital is an absolute must. The following are some commonly used strategies that can help improve your financial standing.

1. Better Understand Cash Flow, Account Receivables, and More

Business owners should start by ensuring that they fully understand their cash flow. Using a business balance sheet to track income and expenses can provide valuable insights regarding the source of money issues that could contribute to negative working capital. Business leaders should also track metrics such as accounts receivable and how long it takes to sell through their inventory.

2. Optimize Billing Cycles

With the above information in hand, business owners can try to negotiate better payment terms with their vendors to optimize their billing cycles. Aligning expenses with estimated sales or securing longer payment terms can help ensure that billing cycles fit the needs of your business. Vendors are most willing to make these arrangements with reliable customers who have a history of on-time payments.

3. Improve Your Invoicing Practices

Trouble collecting invoice payments from slow-paying customers is a common contributor to negative working capital. Start by ensuring that you send invoices in a timely manner and follow up on invoices to ensure on-time payment. Your business could also benefit from offering shorter invoice payment terms, or even implementing early payment discounts or late fees. Such steps will help you get paid sooner so that you have sufficient cash to cover expenses.

4. Use Invoice Factoring

Another option for collecting invoice payments is to use invoice factoring. Invoice factoring lets you sell unpaid invoices for cash to a third-party factoring company, and your company is advanced up to 90% of the invoice’s value. After the factoring company receives payment from your client, you get the rest of the invoice value, minus factoring fees. This way, you don’t have to worry about tracking down late payments.

Negative Working Capital FAQs

Can working capital be negative?

Yes. When current liabilities exceed current assets, you have negative working capital.

What happens when current liabilities exceed current assets?

When your current liabilities exceed current assets, you have negative working capital. Though not always a bad thing, this can leave your business more vulnerable to situations where additional funds would be needed at short notice, such as during a financial downturn or dealing with unexpected legal expenses or repairs.

How much working capital do I need?

While the “right amount” of working capital can vary from business to business, it is generally recommended to aim for a current ratio of 1.5 to 2.0 to ensure you are using assets effectively while also having enough to cover liabilities. To calculate this, divide your total short-term assets by your total short-term liabilities.

What types of businesses experience negative working capital?

Businesses in retail and hospitality frequently experience negative working capital due to high inventory turnover. Businesses like restaurants and retail stores often sell their inventory before they have to pay their suppliers, leaving them with an outstanding liability that they owe for inventory that has already been sold.

How do I avoid negative working capital?

You can avoid negative working capital by carefully tracking your business income and expenses, optimizing your billing cycles to align payments with your income, and improving invoice practices to ensure faster payment from your own clients.