Not having enough cash to keep the lights on is a nightmare scenario for every small business owner. Luckily, there is a common warning sign: working capital (current assets minus current liabilities) dipping into negative territory.
With that said, negative working capital isn’t always bad – when created intentionally, it can be an excellent way to grow your small business.
In this article, you’ll learn:
- What negative working capital means
- Why negative working capital isn’t always negative
- Common paths to negative working capital
What is Negative Working Capital?
Negative working capital occurs when a business’s current liabilities are greater than its current assets. If you have negative working capital, your working capital ratio is below one.
Cash and cash equivalents, accounts receivable, marketable securities, inventory, and prepaid expenses are a few examples of current assets. To qualify as a current asset, there must be a strong likelihood that the asset will be turned into cash within a year.
Current liabilities must be paid in the next year – they include accounts payable, taxes owed within the next year, short-term debts, and dividends payable.
Is Negative Working Capital a Good or Bad Thing?
Negative working capital may sound like, well, a negative thing thus far. But it’s actually not as cut and dried as it seems.
Benefits of Negative Working Capital
For small businesses with excellent growth opportunities, pushing your working capital ratio below one has the potential to turbocharge your small business.
Let’s look at an example:
Mary has an e-commerce business that specializes in home aquariums. The demand for her products is through the roof. Every time she gets a shipment from her manufacturer, she runs out of many products within a few weeks – which results in Mary placing regular orders.
Before long, Mary is one of her manufacturer’s largest customers – she suspects that her orders account for 10-20% of the manufacturer’s revenue. As such, she knows that she has the ability to negotiate favorable payment terms.
She proposes the following to her manufacturer: double the value of her orders and pay in-full 90 days after the delivery of each order, with no interest added on. The manufacturer quickly accepts, thrilled with the huge increase in volume.
Mary now has a lot more cash available, which she invests in marketing and new product designs. At the same time, she is able to immediately increase her sales by getting more products in stock.
As long as Mary has enough cash to satisfy her short-term financial obligations, negative working capital might be a big benefit to her business.
There is risk with negative working capital. For example, Mary’s business might deal with an unexpected decline in demand at some point – which might jeopardize her ability to pay the manufacturer in time.
With that in mind, you should only “go negative” if the risk/reward is very attractive (you have an incredible opportunity in front of you, and you believe there’s a really high chance of success).
Drawbacks of Negative Working Capital
If you have negative working capital, you open your business to possible issues. Here are a few of them:
- Satisfying existing short-term financial obligations: if you have negative working capital, you may be relying on incoming cash to pay your current liabilities. Here’s why: by definition, you don’t have enough current assets to cover your current liabilities.
- Covering unexpected expenses: if everything goes according to plan, negative working capital might not cause any problems for your small business. But what if your company car requires a major repair? Or you have to replace an expensive piece of equipment? Without enough cash in your company bank account, you may be forced to borrow money on short notice – possibly with unattractive terms.
- Securing investment: the vulnerabilities associated with negative working capital are well-known in the business world. This means you may struggle to secure funds from outside investors if you have negative working capital without good reason.
Common Paths to Negative Working Capital
Unless it’s part of a well-thought out strategy, you don’t want negative working capital. So, it’s important to be aware of the common (unintentional) paths to negative working capital.
Negative Operating Cash Flow
If your operating cash flow is negative, you are on the road to negative working capital.
In this case, you may need to use your current assets to not only pay your current liabilities, but also pay your real-time business expenses. So, your current asset position deteriorates, and you move towards negative working capital.
Pay Off Long-Term Debts
Isn’t it a good thing to pay off long-term debts?
Sometimes, yes… but sometimes, no.
Let’s say you take some cash and pay off loans that weren’t due for another five years. If you have excess cash, this may be a good idea. But if the move takes you below a good working capital ratio, you may have made a mistake.
Invest in Long-Term Assets
As with paying off long-term debts, investing in long-term assets may be a good move for your small business. But if you use cash or short-term financing, it’s important to have enough current assets leftover to cover your current liabilities.
How Gravity Capital Can Help You Grow Your Small Business
If you’ve decided that a working capital deficit is necessary to grow your small business, you may want to consider short-term financing to give your small business a cushion.
With Gravity Capital, your repayments are based off of a percentage of your sales, protecting you against the unexpected.
Learn more about Gravity Payments’ quick and easy funding solutions.