Working capital can be negative if a company's current assets are less than its current liabilities. Working capital is calculated as the difference between a company's current assets and current liabilities. This can happen if a company's current assets substantially decrease as a result of large one-time cash payments, or current liabilities increase due to significant credit extension resulting in an increase in accounts payable.
Understanding Working Capital
Working capital can affect a company's longer-term investment effectiveness and its financial strength in covering short-term liabilities. Working capital represents what a company currently has to finance its immediate operational needs, such as obligations to its vendors, inventory, and accounts receivable.
Prepaid expenses are also part of working capital. When conducting valuations, certain investment professionals consider adjusted non-cash working capital that does not include cash and cash equivalents, short-term investments, and any loans and debt payments coming due within a year.
Working capital is calculated as net total current assets, but the netted amount may not always be a positive number. It can be zero or even negative. As a result, different amounts of working capital can affect a company's finances in different ways.
Working capital is a measure of how well a company is able to manage its short-term financial obligations.
Positive Working Capital
When a company has more current assets than current liabilities, it has positive working capital. Having enough working capital ensures that a company can fully cover its short-term liabilities as they come due in the next twelve months. This is a sign of a company's financial strength.
However, having too much working capital in unsold and unused inventories, or uncollected accounts receivables from past sales, is an ineffective way of using a company's vital resources.
The additional funds parked in inventories or receivables are not financed by short-term liabilities but rather long-term capital, which should be used for longer-term investments to increase investment effectiveness. The key is thus to maintain an optimal level of working capital that balances the needed financial strength with satisfactory investment effectiveness. To accomplish this goal, working capital is often kept at 20% to 100% of the total current liabilities.
Zero Working Capital
When a company has exactly the same amount of current assets and current liabilities, there is zero working capital in place. This is possible if a company's current assets are fully funded by current liabilities. Having zero working capital, or not taking any long-term capital for short-term uses, potentially increases investment effectiveness, but it also poses significant risks to a company's financial strength.
Certain current assets may not be easily and quickly converted to cash when liabilities become due, such as illiquid inventories. Keeping some extra current assets ensures that a company can pay its bills on time.
Key Takeaways
- Working capital is the difference between a company's current assets and current liabilities.
- Working capital can be negative if current liabilities are greater than current assets.
- Negative working capital can come about in cases where a large cash payment decreases current assets or a large amount of credit is extended in the form of accounts payable.
- Positive working capital happens when current assets are greater than current liabilities, and zero working capital is when current assets equal current liabilities.
Inside Negative Working Capital
Negative working capital is closely tied to the current ratio, which is calculated as a company's current assets divided by its current liabilities. If a current ratio is less than 1, the current liabilities exceed the current assets and the working capital is negative.
If working capital is temporarily negative, it typically indicates that the company may have incurred a large cash outlay or a substantial increase in its accounts payable as a result of a large purchase of products and services from its vendors.
However, if the working capital is negative for an extended period of time, it may be a cause of concern for certain types of companies, indicating that they are struggling to make ends meet and have to rely on borrowing or stock issuances to finance their working capital.
The amount of a company's working capital changes over time as a result of different operational situations. Thus, working capital can serve as an indicator of how a company is operating. When there is too much working capital, more funds are tied up in daily operations, signaling the company is being too conservative with its finances. Conversely, when there is too little working capital, less money is devoted to daily operations—a warning sign that the company is being too aggressive with its finances.
