Adjusted working capital definition
/What is Adjusted Working Capital?
Adjusted working capital is designed to strip liquid and non-operational (i.e., financing) elements away from the traditional measure of working capital. By doing so, what is left in the measurement relates to the purely operational aspects of a business. One can then focus on these remaining elements to see how well a company is being operated. The adjusted working capital figure is best tracked as a proportion of sales on a trend line. If the proportion is declining over time, this indicates good management of company operations, so that receivable and inventory investments are kept low in proportion to sales.
Calculation of Adjusted Working Capital
To calculate adjusted working capital, add together the ending balances in the accounts receivable and inventory accounts, and subtract out the ending balances in the accounts payable and accrued operating liabilities accounts. The formula is as follows:
Accounts receivable + Inventory - Accounts payable - Accrued operating liabilities = Adjusted working capital
What is of considerable importance in this calculation is what not to include. We do not include cash or marketable securities, nor do we include the current maturities of any notes payable or debt payable.
When to Use Adjusted Working Capital
Adjusted working capital strips away those elements of the working capital calculation that do not relate directly to operations, allowing us to see how well the short-term assets and liabilities of a business are being utilized to run operations. The measure is particularly appropriate for highly profitable companies that are retaining their profits in cash and investments; using the traditional working capital figure makes their working capital number look too high in comparison to sales, and so does not reveal their ability to manage assets and liabilities. Using the adjusted working capital measurement corrects the situation.
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Problems with Adjusted Working Capital
The measurement can yield misleading results. For example, management may conclude that it is profitable to increase sales by loosening credit terms, which will increase the proportion of accounts receivable to sales. If their strategy works, overall profits (and presumably cash flow) will increase, even while the proportion of adjusted working capital to sales worsens.