The company’s working capital is calculated using the current assets and the current liabilities declared by the company in the financial records, which are officially released. The current assets are the assets of a business that can be monetized over a period of one year. This included bank balances, investments, accounts receivables. Similarly, the current liabilities are the amounts that have to be paid by the company to its debtors within the next one year period. The difference between the current assets and current liabilities is the working capital of the company. In some cases or industry sectors, the business’s current liabilities will exceed the current assets, and the business will have negative working capital. This may be intentional because of the business model or due to unexpected business-related problems.
What if working capital is negative?
Negative working capital represents the situation when the company’s current liabilities exceed its current assets as stated on the firm’s balance sheet. Negative working capital can be an advantage in business processes and disadvantages. If the company generates cash quickly because it can sell products to its customers before it has to pay the bills to its vendors, negative working capital is positive company performance.
The negative working capital advantage
However, companies looking for takeover targets should be aware that there are some business models where negative working capital is considered a positive attribute. One of the most famous brands used in negative working capital case studies is Dell Computers, whose business model allows it to have negative working capital for many years. The company is collecting cash from customers upfront when they place their order. However, it is paying the suppliers of computer hardware and other services later. In general, very few well-known companies have a major advantage over their competition, which allows them to have negative working capital.
Yet, Dell computers’ case shows that negative working capital may be considered a positive feature of the business in certain industry sectors while evaluating businesses for takeover.
The negative working capital disadvantage
Most company buyers will consider the negative working capital of business a major disadvantage when evaluating various businesses for takeover. This is because the company’s buyer will have to arrange for additional funds for working capital for running the business after the business purchase deal has been finalized. Typically the companies looking for a takeover target are also checking the working capital ratio of the business. Usually, most buyers will prefer a business with a working capital ratio of at least 1 to 1.5. This ensures that the business has assets that are valuable enough to cover the current liabilities. The company buying the business can be assured that in this case, the company itself is generating enough cash to be able to pay suppliers and employees in the short term.
Negative working capital and carry
Another factor that determines the desired networking capital ratio is the carrier for the business model. A business has a long carry if the time period required to receive the payment from customers, that convert the receivables to money in the bank account, is far longer than when the business is allowed to make the payment due to its employee’s suppliers. In this case, the experienced and competent buyers will want a working capital ratio that is much higher than the standard ratio since the long carry period will affect the business’s cash flow.