Dissecting Working Capital

Working capital is the difference between a business' current assets and liabilities. Negative working capital can happen when a business' current assets are below its current liabilities. Therefore, working Capital = Accounts Receivable + Inventory - Accounts Payable. It's a way to measure a company's ability to meet short-term liabilities, such as managing inventory, satisfying vendor bills, etc., and how well its longer-term investments are implemented.

When a business has a surplus of current assets against its current liabilities, it's said to have positive working capital. Generally speaking, when it's positive, the business is able to service liabilities over the next 12 months, putting it in a good financial position. However, it's important to understand how positive working capital is comprised. If a business has a sizeable outstanding accounts receivable account or has too much inventory, the company's resources are not utilized efficiently. With money tied up in such areas and not financed by short-term liabilities, but with long-term capital, the long-term capital can't be used for long-term investments.  

When working capital is either even or negative, it's a way to gauge how (in)efficiently a business handles near-term financial obligations. Reasons why negative working capital exists include a business making one-time cash payments due to a business' current assets markedly dropping. Similarly, current liabilities can increase massively with more accounts payable and increasing credit.

Delving into Negative Working Capital

When analyzing negative working capital, it's important to see how it's connected to the current ratio. The current ratio is a business' current assets divided by its current liabilities. When the current ratio's calculation is less than 1.0, the business has more current liabilities than current assets, resulting in negative working capital.

Temporary negative working capital may exist when a company spends excessively or sees a steep increase in outstanding bills due to buying input materials and services from its suppliers. Though extended periods of negative working capital could be a red flag because the business might have a problem paying immediate bills and is being forced to depend on financing or raising funds via equity issuances to manage its working capital, it gives insight into the company's financial barometer.

Negative Working Capital Requires Judgment

Depending on the type of business and its working capital levels, a negative working capital figure may or may not indicate there's a concern. Retail, grocery, and subscription negative working capital may not be bad; however, for capital-intensive companies, negative working capital might indicate trouble. One way to measure working-level capital is through the Cash Conversion Cycle (CCC). The CCC determines whether negative working capital is from efficient operations or cash flow constraints.

It looks at:

1. Days Inventory Outstanding (DIO) or how long the inventory waits before a sale is made.

2. Days Sales Outstanding (DSO) or how long before an invoice is paid to the company.

3. Days Payable Outstanding (DPO) or how many days it takes a company to pay its vendors’ invoices.

Where: CCC = DIO + DSO – DPO

If the resulting number from the CCC is negative, it indicates the company is receiving payments from its customers well before it needs to pay vendors/suppliers. A company with this type of result is in good shape financially. However, if the CCC is positive and meets some of the criteria, it would require further investigation to see if the negative working capital is worrisome. Examples of a company's poor operation include higher accounts payable days, turnover slows, falling revenue, and accounts receivable collection timeframes increasing.

Conclusion

When it comes to working capital, it requires analysis as to why a company's working capital level is at the level it is. Taking the level at face value doesn't give the evaluator the full picture.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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