Negative Working Capital

Negative Working Capital Formula

Just as a quick preface before we begin, the term “working capital” will be used interchangeably with “net working capital.”

In accounting textbooks, working capital is typically defined as:

Working Capital Formula

• Working Capital = Current Assets – Current Liabilities

By contrast, the net working capital (NWC) metric is similar but deliberately excludes two line items:

1. Cash and Cash Equivalents
2. Debt and Interest-Bearing Securities

The net working capital (NWC) metric reflects the amount of cash tied up in a company’s operations.

Net Working Capital Formula (NWC)

• Net Working Capital (NWC) = Current Assets (Excluding Cash & Equivalents) – Current Liabilities (Excluding Debt and Interest-Bearing Liabilities)

Unlike operating current assets and current liabilities such as accounts receivable and accounts payable, cash and debt are non-operational – i.e. neither directly create revenue.

NWC captures the operating current assets and current liabilities to quantify the minimum cash balance, which is the amount of cash required to be on hand for operations to continue running as usual.

• If Current Assets > Current Liabilities → Positive Working Capital
• If Current Assets < Current Liabilities → Negative Working Capital

The latter scenario is what we’ll focus on, as the concept can initially be trickier to understand.

How to Interpret Negative Net Working Capital (NWC)

Negative Net Working Capital → “Good” Sign?

For companies with more current liabilities than current assets, the instinctual response is to interpret the negative working capital unfavorably.

However, negative working capital can generate excess cash flows – assuming the cause of the negative NWC balance is driven by operating efficiency, as we’ll explain shortly.

If working capital is negative from the accumulation of owed payments to suppliers, the company is holding onto more cash during the delayed payment time span.

The supplier payment will eventually be issued since the product/service was received, but certain companies with buyer power can extend their days payable (e.g. Amazon) – which essentially causes the suppliers/vendors to provide “financing.”

For an example of an operating current asset, a low accounts receivable (A/R) value on the balance sheet implies the company is effective at collecting cash payments from customers, whereas high A/R values mean the company is facing difficulty retrieving payments owed by customers.

Negative Net Working Capital → “Bad” Sign?

Nevertheless, a negative NWC is not always a positive sign, either.

As mentioned earlier, extending payables can make suppliers/vendors act similar to providers of debt capital, just without carrying interest expense as with lenders.

Yet, the payments that the suppliers/vendors are owed are contractual agreements in which a service or product was delivered in exchange for either cash payment or the reasonable expectation of payment.

With that said, suppliers can eventually attempt to collect payment through legal means – and if a company is struggling to make supplier payments, it’s probable that debt lenders aren’t getting paid, either.

In effect, the leverage over suppliers that has benefited the company can easily backfire if there is a sudden downward trajectory in performance.

Likewise, the same type of scenario can occur for accrued liabilities – i.e. payments owed to third parties such as rental payments to a landlord and utility bills.

Cash Flow Impact of Negative NWC

All else being equal, negative net working capital (NWC) leads to more free cash flow (FCF) and a higher intrinsic valuation.

The general rules of thumb regarding the impact of working capital changes on cash flow are shown below.

• Increase in Operating Current Asset = Cash Outflow (“Use”)
• Increase in Operating Current Liability = Cash Inflow (“Source”)

For example, accounts receivable (A/R) increases if more revenue “earned” under accrual accounting standards has yet to be collected, whereas if accounts payable (A/P) increases, that means the suppliers are still waiting to be paid.

In a discounted cash flow analysis (DCF), whether it uses free cash flow to firm (FCFF) or free cash flow to equity (FCFE), an increase in net working capital (NWC) is deducted from the cash flow value (and vice versa).

Negative Working Capital Calculator

Now that we’ve discussed the meaning behind negative working capital, we can complete a practice modeling exercise in Excel. For access to the file, fill out the form below.

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Negative Working Capital Example Calculation

In our illustrative example, a simple working capital table for two periods has been provided.

Model Assumptions

From Year 1 to Year 2, our company’s operating current assets and operating current liabilities undergo the following changes.

Current Assets

• Accounts Receivable = $60m → $80m
• Inventory = $80m → $100m

Current Liabilities

• Accounts Payable = $100m → $125m
• Accounts Payable = $45m → $65m

In Year 1, the working capital is equal to negative $5m, whereas the working capital in Year 2 is negative $10, as shown by the equations below.

• Year 1 Working Capital = $140m – $145m = – $5m
• Year 2 Working Capital = $180m – $190m = – $10m

The negative working capital values stem from increases in accounts payable and accrued expenses, representing cash inflows.

On the other side, accounts receivables and inventory also increase, but these are cash outflows – i.e. the build-up of purchases made on credit and unsold inventory.

In Column “I”, we can see the change between the two values and the cash impact.

Change in NWC Formula

• Change in Current Assets = Current Balance – Prior Balance
• Change in Current Liabilities = Prior Balance – Current Balance

For example, A/R increases by $20m year-over-year (YoY), which is a “use” of cash amounting to negative $20m. And then for A/P, which increases by $25m YoY, the impact is a “source” of cash of $25m.