Spending cash from customer sales before you have to pay your suppliers for the goods or raw materials involved might sound like a risky strategy. But being in controlled periods of what’s defined as negative working capital can be the making of businesses that generate cash quickly and have a firm grip on their finances.
In this article, we will provide a definition of negative working capital, the advantages and disadvantages it can bring to your business and some top tips on how to safely manage it across your organisation.
What is negative working capital?
Negative working capital is when a business’s current income and realisable assets won’t cover its liabilities for the year. Clearly, no firm wants to put itself in a position where it can’t pay staff or its bills. But it could be that income generated quickly and profitably could provide you with ready cash for strategic business expenses such as investing in more stock, new products or equipment.
Whatever your order book looks like, you always need to know where you stand with your working capital. It's crucial to subtract what you owe from what you have – and there’s a working capital formula to help you to calculate these numbers.
Successful businesses have a complete grip on their working capital cycle – the time it takes to turn current assets into money in the bank – to help them understand how to use negative working capital in the full knowledge of how much they will need to pay suppliers' bills, payroll or other regular expenses.
The working capital cycle comprises four phases:
- ensuring healthy inflows and outflows of cash
- optimising customer payment terms or receivables
- keeping tabs on the time taken to sell inventory
- managing billing, which is how long you have to pay suppliers.
Tony Groom, a Financial Change Advisor and Chairman of turnaround firm K2 Partners says it's crucial to interrogate what you spend your money on – as well as the reasons behind it – if you do decide to dip into negative working capital. For example, using cash reserves to pay off debts could compound your negative working capital state and make it difficult to get the balance swinging in a positive direction to fuel business growth.
We can help keep your working capital in check so that when you need to pay suppliers and meet everyday financial obligations, you’ll have up to 54 days¹ to clear your balance with the American Express® Business Gold Card. That way, you can keep money in your business for longer and manage expenses over a timeframe that suits you.
What happens when you have negative working capital?
If negative working capital becomes a permanent state, a business will find itself unable to meet everyday expenses – such as paying staff or suppliers – and may have to stop trading.
Is negative working capital good or bad?
Utilising negative working capital is a strategy often followed by fast-growing, high-turnover companies that don’t supply goods on credit. They have tight control over their inventory, strong brands and the muscle power to bargain with suppliers.
Disadvantages of negative working capital
Businesses that have negative working capital have little headroom to take up the many opportunities that come their way to innovate, expand or take over rivals. And it can also impact your plans to fund expansion as investors who see negative working capital on the balance sheet may take it as a possible sign that sales are poor or customer invoices are not being paid.
A lack of ready cash can also regularly disturb the company's functions, making it hard to pay staff and distracting management from focusing on customers and business as usual. Business life is also unpredictable, and more funds may well be needed at any one time for anything from repairs or legal expenses to riding out an unforeseen fall in sales.
Lastly, SMEs with negative working capital who pay their suppliers late or need to extend payment terms may earn you a poor reputation and place you in a weakened negotiation state.
Advantages of negative working capital
A key advantage of negative working capital is the ability to invest strategically to fund fast growth. One of the first entrepreneurs to utilise this strategy was Sam Walton, Founder of US retail giant WalMart. He ordered vast quantities of stock and sold it on at a profit many weeks before he had to pay for it – freeing up the means to pay for further goods and to expand his empire.
Chief Executive of specialist enterprise telecom hardware and software company Track4Services, Derek Greene, says his firm has been taking advantage of a period of negative working capital caused by a slow down in orders because of volatile market conditions. He has invested cash into upgrading one of its most popular products – a wifi device that provides five days of emergency connectivity – by reducing the amount of time it takes to charge from 12 hours to six minutes.
“[During this period] I also asked my team to make product videos and documents with lots of photos and we are now using these daily for the betterment of the company," says Greene, claiming that both investments have resulted in a "strong boost" in sales for the company.
What types of companies typically have negative working capital?
Large food stores, online and discount retailers, fast food restaurants, utilities, software and telecom companies are among those most likely to have negative working capital.
Shares Magazine noted grocery retailer Sainsbury’s has negative working capital topping well over a billion pounds . That’s because stock is turned rapidly into cash at its checkouts long before it has to be paid for. As Groom puts it, such companies are “effectively funding the business with their suppliers' credit”.
What could be the impact of negative working capital on a company valuation?
Groom says where an SME's working capital is seen to be negative, any investor attempting to value the business will "definitely want to see rising revenues". That’s because falling revenues often signal poor liquidity – an inability to readily convert any assets the company owns into cash. A company that consistently has more current liabilities than current assets will not look like an attractive prospect to investors.
How to avoid negative working capital
Take control of your working capital by picking the period you want to plan for and list all your income and outgoings. This cash flow forecast will help identify shortfalls ahead, potential problems with incoming payments and help you to see where resources are being wasted or tied up in stock for too long. It's also important to ensure pricing and invoice decisions are not made in silos. For example, a central finance drive to bring in cash more quickly might be undermined by longer credit terms being offered elsewhere within the company.
In a bid to avoid negative working capital, Groome has tried and tested many strategies including reducing the work it gave to even its most valued contractors to minimise cash going out of the business too fast and at one point directors received no pay for six months.
A key objective in avoiding negative working capital should be shortening your working capital cycle. Here’s a useful checklist to get you started:
- Track your working capital ratio
- Automate your business financing processes
- Improve your inventory management
- Look for ways to boost your sales revenue
- Avoid unnecessary outgoings and expenses
Effective working capital management – safely freeing up cash that would otherwise be locked away for longer – is an important business tool in your journey to avoid negative working capital and ensure both the sustainability and growth of your business.
Another way you can free up working capital is by using your American Express Business Gold Card for your everyday business expenses. Each £1 you spend earns you 1 Membership Rewards® point that you can redeem with hundreds of retailers on items such as office supplies, IT equipment or employee perks².
- The maximum payment period on purchases is 54 calendar days on Gold & Platinum Business Charge Cards and 42 calendar days on the Basic Business Charge Card, it is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.