Negative Working Capital

Definition - What does Negative Working Capital mean?

Negative working capital is the situation where a company's current liabilities exceed its current assets. This means that the liabilities of the company that need to paid within one year exceed the current assets 

Negative Working Capital

A buyer actually prefers to see a working capital ratio of 1.0 - 1.5x, which means there is at least one dollar of current assets for every dollar of current liabilities. This assures the buyer that the company can generate sufficient cash over the short run to cover  and supplier and payroll obligations. However, smart buyers will look for an even higher net working capital ratio . This carry means that there may be a much longer period to convert receivables to cash than it takes to pay accounts payable.

That being said, there are some businesses in which negative working capital is a positive. The famous case study is Dell Computer, which for years had negative working capital as a result of its business model that allowed it to collect cash up-front but pay suppliers later.

Such situations result from a competitive advantage are more the exception than the rule.

The bottom line: A negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis). In any other situation, it is a sign a company may be facing bankruptcy or serious financial trouble.

When Wal-Mart ordered the 500,000 copies of a DVD, they were supposed to pay Warner Brothers within 30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores across the country? By the twentieth day, they may have sold all of the DVDs. In the end, Wal-Mart received the DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesn't really need to have enough cash on hand to pay all of its accounts payable. As long as the transactions are timed right, they can pay each bill as it comes due, maximizing their efficiency.

Things to Remember

If the ratio is less than one then they have negative working capital. A high working capital ratio isn't always a good thing, it could indicate that they have too much inventory or they are not investing their excess cash.

Examples

1. McDonald's had a negative working capital of $698.5 million between 1999 and 2000). 
2. Amazon.com is another example.
3. Dell

Types of Mathematical Averages

When computing means, the type of mean you need to use depends on the type of data you are analyzing.

arithmetic mean

For example, the arithmetic mean of 2, 5, and 14 is (2+5+14)/3 = 7. 

The essential property of any mean is that it must fall between the highest value and the lowest value.

Geometric Mean

(x₁·x₂·...x_n)^1/n

For example, suppose a business's profits grow by 25% one year, and by 45.8% the next year. To find the average yearly percent growth rate, you must take the geometric mean of 1.25 and 1.458.

sqrt[(1.25)(1.458)]
= sqrt[1.8225]
= 1.35

Thus, the average growth rate over the two years was 35%. 

Compare this to the result you would get if you took the arithmetic mean of 25 and 45.8. Since (25+45.8)/2 = 35.4

Harmonic Mean

In science in business applications, the harmonic mean is used to average ratios. 

For two numbers x and y, the harmonic mean is 2xy/(x+y). 

For three numbers x,y, and z, the harmonic mean is 3xyz/(xy+xz+yz).

For n numbers, the harmonic mean is

n/(1/x₁ + 1/x₂ + ... + 1/x_n)

For example, suppose a man drives at a speed of 80 k/h for 100 kilometers (1.25 hours), and then drives at a speed of 40 k/h for the next 100 km (2.5 hours). The average speed of the car for the entire 200 km trip is total distance divided by total time. Since 200/(1.25+2.5) = 53.33, the average speed is 53.33 k/h. This is equivalent to the harmonic mean of 80 and 40. Observe:

2(80)(40)/(80+40)
= 6400/120
= 53.33

In business, investors use the harmonic mean to compute the average price/earning ratio of a stock portfolio. For example, suppose you have three stocks, and their P/E ratios are 8, 18, and 30. The average P/E ratio of the three stocks is 

3(8)(18)(30)/(144+240+540)
= 12960/924
= 14.026

Root Mean Square (Quadratic Mean)

The root mean square, aka quadratic mean, is used in many engineering and statistical applications, especially when there are data points that can be negative. The standard deviation of a set of numbers is an example of the root mean square. (It is the root mean square of the differences between each data point and the arithmetic mean.) If you have two numbers x and y, the quadratic mean is sqrt[(x² + y²)/2]. For n variables, it is

sqrt[(x₁² + x₂² + ... + x_n²)/n]

For example, suppose you have this set of numbers: -10, -5, -4, 1, 6, 7. The root mean square is

sqrt[(100+25+16+1+36+49)/6]
= sqrt(227/6)
= 6.15

which can be interpreted as the average positive value.

Contraharmonic Mean

The contraharmonic mean of x and y is (x² + y²)/(x + y). For n values, the contra- harmonic mean is

(x₁² + x₂² + ... + x_n²)/(x₁ + x₂ + ... + x_n)

For example, the contraharmonic mean of 1, 3, 5, and 7 is

(1+9+25+49)/(1+3+5+7) = 84/16 = 5.25

Other Means

[(x^p + y^p)/2]^1/p    (Power Mean)

[(x^p - y^p)/(p(x - y))]^1/(p-1)    (Stolarsky Mean)

        sqrt[(x² + xy + y²)/3] when p = 3

(x^p + y^p)/(x^p-1 + y^p-1)    (Lehmer Mean)

[(x^p + y^p)/(x^r + y^r)]^1/(p-r)

[(r(x^p - y^p))/(p(x^r - y^r))]^1/(p-r)

[(x^py^r + x^ry^p)/2]^1/(p+r)

(x - y)/(Ln(x) - Ln(y))    (Log Mean)

(xLn(x) + yLn(y))/(Ln(x) + Ln(y))

(x + sqrt(xy) + y)/3    (Heronian Mean)

(1/e)(x^x/y^y)^1/(x-y), e = 2.718281828....    (Identric Mean)

(e)(x^y/y^x)^1/(y-x)

(x^xy^y)^1/(x+y)

(x^yy^x)^1/(x+y)

Mean Inequalities

Some means are in a constant relationship to one another. If we denote the arithmetic mean of x and y by A, their geometric mean by G, their harmonic mean by H, their root mean square by R, and their contraharmonic mean by C, then the following chain of inequalities is always true

C ≥ R ≥ A ≥ G ≥ H