Negative working capital: definition, interpretation and advantages

Working capital requirement (WCR) is one of the key concepts you need to know in order to manage your company's cash flow effectively. WCR can be calculated as either a positive or negative figure.

But perhaps counterintuitively, negative working capital requirements are very often a great thing. This can unlock and accelerate serious growth.

This article shows you how to calculate your working capital requirement and determine whether or not it is negative. Then we’ll look at ways to reduce WCR as much as possible and move towards a negative amount, through internal actions within the company or through access to short-term financing.

1 - What is negative working capital?

Before talking about negative working capital, let's start by clarifying the concept. We have devoted an entire article to the definition, calculation and management of working capital requirements.

1.1 - Definition of working capital requirement

Every business needs money to run its day-to-day operations. It has to buy goods or services and pay for them, before selling them on to customers. Often, products are held in stock for some time before being sold. 

All these operations are regularly repeated week after week. This cash flow gap between cash outflows and inflows is known as the working capital requirement or WCR.

1.2 - Working capital formula & implications

The formula for calculating WCR is simple: (inventories + receivables) - (operating liabilities). In other words, your current assets minus current liabilities. Depending on the size of each amount, the calculation will result in either a positive or a negative balance. 

This is why you come across the terms positive WCR or negative WCR in corporate financial analysis. Sometimes, the notion of a “working capital surplus” is used when the amount is less than zero.

1.3 - Negative working capital can be confusing

The word negative usually indicates something... negative. You immediately think that the indicator is bad or insufficient. 

But in the case of negative WCR, this is excellent news for managing your operating cash flow. It shows that you are bringing cash in (selling) faster than you’re spending.

2 - How to interpret your WCR

To better understand how a negative WCR works, let's first look at the meaning of working capital. It shows the level of cash a company needs for its day-to-day operations. 

[Bear in mind that seasonal activity can lead to significant variations in WCR over the course of a year. And, if sales increase, you can also expect a significant rise in the ratio.]

2.1 - Positive WCR usually means a need for financing

Let's take an example. In your company’s accounts, inventory on hand totals €800 and receivables of €500 - these are your current assets. With supplier debts of €400 and social security debts of €80, the company's WCR is calculated as follows:

• Current assets: €800 + €500 = €1,300
• Current liabilities: €400 + €80 = €480
• WCR = €1,300 - €480 = €820

The average working capital requirement for this company is €820 — you need this amount of cash in the bank to operate. You want to honour supplier debts and buy stock while waiting to invoice customers and collect sales.

Suppose you happen to have operating cash of exactly €820 on hand. You can manage the positive working capital requirement with zero funds to spare. In reality, this is incredibly rare.

More often for small businesses, cash on hand is limited — let’s say €200. In this case, your company faces a working capital requirement shortfall of €620 (820-200). You’ll need working capital financing or some other form of short-term loan while you wait to be repaid by customers.

2.2 - Negative WCR, a surplus of financial resources from operations

Let's take a second example. The company has the following accounting data:

• Current assets: inventories of €300 and receivables of €50 = €350
• Current liabilities: supplier debts of €400 + social security debts of €80 = €480
• WCR = €350 - €480 = -€130

In this case, the WCR means that on average there is always €130 cash available. If, in addition, the WCR is €200, for example, then the net cash in the bank is (€200 + €130) = €330.

The crucial element here is your cash conversion cycle — the dates when each of these assets and liabilities come due. If you can delay paying suppliers longer than it takes to collect from customers, you have additional cash to invest elsewhere. This is what makes negative WCR such a growth lever. 

2.3 - Business sectors with a WCR of less than zero

Companies with few, if any, outstanding customers on the assets side of the balance sheet have negative WCR. So the shorter your Days Sales Outstanding (DSO), the better. This is even more true when these same businesses issue supplier payments with long lead times. 

This type of WCR is generally found in the retail, mass distribution and catering sectors, where customers typically pay in cash.

3 - Why is a negative WCR actually positive?

Negative WCR offers a number of practical advantages for running a business. Most vitally, it’s a real opportunity to finance new initiatives and invest in growth.

3.1 - Self-financing of day-to-day business activities

With a negative WCR, the company is free to decide what to do with its expenditure, purchases and supplies. It doesn’t need to count every penny and check the cash flow plan in detail before placing an order with its suppliers.

The cash conversion cycle is self-financing for the company. It doesn’t depend on investors, banks or financial institutions to maintain operations.

3.2 - Use a working capital surplus for other purposes

If your business generates a working capital surplus (negative WCR), you can use this money elsewhere. In effect, your operating cycle generates surplus cash. So it's an ideal accounting situation — a sign of good financial health that makes day-to-day management easier.

You can make self-financing investments, even if the top end of the balance sheet is not logically financed by the bottom end. You can also invest surplus cash. And if you’re planning a sales growth phase, you will have enough money to build up additional inventory.

3.3 - Negative WCR can be optimised

This type of working capital surplus can be found in certain areas of business, as mentioned above. Even if you’re not among these, you can still optimise your working capital and get below zero by pulling certain levers.

4 - How to reach a negative working capital requirement

The notion of negative WCR can be frightening, as it implies having supplier debts that remain unpaid for some time. But mathematically this is a good thing, as we have just demonstrated in the previous examples. 

But outside of increasing supply invoice repayment periods, there are other, more win-win solutions for you and your partners.

4.1 - Internal actions to reduce WCR

Whatever the level of your working capital requirement, the more you can reduce it, the better your cash position. 

Start by analysing the key factors used to calculate WCR, in particular inventories and receivables. The main actions are as follows:

• Take tight control of inventories to avoid overstocking, which represents tied-up cash
• Monitor receivables closely, in particular through debt collection and reminder procedures. Do your best to get paid on time!

We describe these in more detail in our article on levers optimising working capital.

4.2 - Short-term financing solutions that solve positive WCR problems

The other way to work towards negative working capital is to finance one of the items that make up WCR. This type of financing makes life easier for companies whose positive WCR remains high.

Here are some solutions to consider for short-term financing for SMBs which avoid the need to use the company's own cash reserves:

• Arrange for supplier debts to be paid by a third party (to be repaid at a later date, once the money from sales has been received).
• Use invoice financing to cover customer receivables as soon as invoices are issued. You get a cash advance from a third party, to be repaid when the customer pays.

Negative working capital is great. Financing solutions can help.

Negative working capital is good news for almost any small business. But it's not always possible to pull enough levers to bring your working capital requirement below zero.

So don't panic. Today's SMBs have access to agile, easy-to-implement financing solutions to ease their cash flow. 

At Defacto, we've designed our online platform with just that in mind: to give you the peace of mind to develop your business at your own pace and without constraints. Find out more and see if you’re eligible.