Negative Working Capital vs Postive Working Capital

We find that the difference between neutral, negative, and positive working capital causes a great deal of confusion for many business owners.

Most business people see working capital and think of fixed asset expenditures or view working capital as periodic instead of systematic. Working capital expenses are not listed as “other expenses” like apparently similar operating expenses; they seem to be invisible.

Working capital expenses are systematic and change daily, producing increases or decreases to the company’s cash holdings. Working capital expenses cannot be ignored … at least not for very long!

So, what makes up working capital? In a basic sense, working capital is made up of current assets and current liabilities. The real major drivers of working capital are commonly:

• Accounts receivable
• Inventory
• Prepaid balances in current assets and accounts payable
• Other payables
• Unearned income in the current liabilities.

The difference between the dollar amounts in each of these in the current assets minus the dollar amounts of each in the current liabilities will determine our working capital position. The working capital position can be positive working capital (current assets exceed current liabilities), neutral working capital (current assets are equal to current liabilities) or negative working capital (current assets are less than current liabilities).

A positive working capital position, while the most common, it is not necessarily the most beneficial. A positive working capital position occurs when the current assets exceed the current liabilities. The difference between the two is the working capital position of the company and needs to be funded and increased in line with revenue growth if the working capital structure remains the same.

As an example, if you have $700,000 in current assets (made up of let’s say just inventory and accounts receivables) and have $400,000 in current liabilities (accounts payable and other payables), then the company’s working capital position is $300,000. If revenues were to increase a real growth of 10% and the working capital structure remained the same the company would need to fund an additional $30,000, which would be the working capital expense for the year.

Note that numerous financial people mistakenly call this the “net working capital position.” Actually, net working capital position is working capital minus the long term debt position of the company. A positive working capital position means a company has to continuously invest into a net positive position with after tax dollars.

A neutral working capital position is where the major drivers of current assets and current liabilities match each other dollar for dollar every year. In this working capital position, the company can grow without needing additional dollars for needed annual increase in working capital. For years, Anheuser Busch, the beer manufacturer now owned by InBev, constantly maintained a neutral working capital position so that the working capital never would need any funding year over year. This potentially eliminated cash flow expense, increasing the company’s cash flow before financing to a permanent higher level as long as the position was maintained.

The last working capital position is a negative working capital. This exists when the drivers of current assets are less than the drivers in the current liabilities. If a company is growing, this can be the most advantageous working capital position because it literally “coins” money for the company. This position really came into use in the dotcom era. While often misused causing a great deal of ultimate financial harm, it has been skillfully and successfully used by many responsible companies, such as Microsoft and Amazon.

The danger with the negative working capital is twofold.

1. First, some industries cannot and should not use it at all (such as Ford Motors that early recognized the mistake and changed to a neutral working capital position before the worst part of the 2008 recession began)
2. Second, the negative working capital position only works when the company is growing revenues (such as General Motors that used it for several years until revenues began declining). When the company’s revenues are declining the positive effect of a negative working capital position reverses and it immediately starts needing annual working capital investment during a time when the company can least afford it.

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