Innovation and expansion sit at the heart of business growth, but neither is possible without adequate working capital. What happens if you’ve used the working capital formula to assess your assets and liabilities and ended up with a negative figure? We’ll discuss the differences between positive and negative working capital below, as well as what they mean for your business.
What is working capital?
Working capital refers to the value left over after all short-term debts have been satisfied with current assets. The working capital formula is written out as:
Working Capital = Current Assets – Current Liabilities
Current assets include things like cash, inventory, and accounts receivable. Current liabilities include any short-term debts, including accounts payable.
Provided that you have access to all company accounts, using the working capital formula is straightforward. After subtracting all current liabilities from current assets, the difference in dollar amounts determines a company’s net working capital position. This can be positive, negative, or neutral. It offers a quick snapshot of how well a company is currently meeting its financial obligations, as well as how much money remains to put back into the business.
Understanding positive vs. negative working capital
Working capital gives a dollar value to the current ratio, or the difference between current assets and current liabilities. However, the current ratio uses a slightly different approach to assets and liabilities than the working capital formula. Instead of subtracting, it divides assets by liabilities.
Positive working capital shows that your business has sufficient liquid assets to pay off immediate debts. By contrast, negative working capital shows that you would struggle to pay immediate debts if restricted only to your current assets. This could be a temporary loss of liquidity caused by a recent cash payment or credit extension.
So, why is positive and negative working capital important? It’s a useful measure of financial health and approach to risk. Investors will look at the working capital position to see how your business is managing its assets.
Positive working capital example
When a business’s current assets outweigh its current liabilities, it’s said to have positive working capital. In other words, there is less risk that the business will be unable to pay its short-term debts.
As a positive working capital example, imagine that Company A has $500,000 in current assets and $300,000 in current liabilities. Its net working capital is $200,000, representing the remaining assets with a dollar value.
What does this mean? To begin with, it shows Company A is sufficiently managing its short-term debts. It also shows that the company has capital to work with. It could use this money on a marketing campaign, product development, or other new project. However, if the business doesn’t do anything with its positive working capital, this can be a red flag to investors who may wonder if the company is missing out on growth opportunities.
Neutral working capital example
In the next financial quarter, imagine that Company A now has $400,000 in current assets, but its current liabilities have grown to $400,000 due to a credit extension. Its current assets and current liabilities cancel each other out, dollar for dollar. This indicates that the company can still meet its short-term debt using its current assets. Yet at the same time it might indicate a higher level of risk, without excess assets that can easily be converted to cash for growth.
Negative working capital example
Now that we’ve looked at positive and neutral working capital positions, it’s time to turn to the negative. As a negative working capital example, imagine that Company A has faced several expenses in the recent financial quarter, leaving it with $250,000 in current assets. Its current liabilities are $350,000, giving it a negative working capital of $100,000.
What does this negative figure mean for the business? On the surface, it shows that if the company had to pay off all its short-term debts today, it would struggle. The company would need to immediately try and push through sales or take on short-term funding to pay its debts. An inability to pay vendors, employees, and bills is a red flag to investors and lenders alike. This also leaves the business with nothing to fuel further growth and investment, as all current assets are tied up with daily operational costs.
Overall, it’s natural for a company’s working capital to ebb and flow as it handles its investments and expenses. While a short-lived period of negative working capital can be easily turned around, when it becomes a long-term situation, this could lead to bigger problems down the road.
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