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. You 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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Example of Adjusted Working Capital
Consider a manufacturing company, Twizzle Ltd., with the following balance sheet items (in $ thousands):
Current Assets:
Cash: $200
Accounts Receivable: $800
Inventory: $1,000
Prepaid Expenses: $100
Current Liabilities:
Accounts Payable: $600
Accrued Expenses: $200
Short-term Debt: $300
Taxes Payable: $100
The company’s traditional working capital is calculated as follows:
Current Assets – Current Liabilities
= ($200 + $800 + $1,000 + $100) – ($600 + $200 + $300 + $100)
= $2,100 – $1,200
= $900
However, adjusted working capital removes liquid and non-operational items such as cash (highly liquid and not part of operations) and short-term debt (a financing item), providing a clearer view of operational efficiency. Let’s adjust the standard working capital figure to arrive at the firm’s adjusted working capital number:
Adjusted Current Assets = Accounts Receivable + Inventory + Prepaid Expenses
= $800 + $1,000 + $100 = $1,900
Adjusted Current Liabilities = Accounts Payable + Accrued Expenses + Taxes Payable
= $600 + $200 + $100 = $900
Adjusted Working Capital = Adjusted Current Assets – Adjusted Current Liabilities
= $1,900 – $900 = $1,000
This adjusted figure reflects only the operational components necessary to run the business day-to-day. By excluding cash and short-term debt, we gain a more accurate measure of the capital tied up in operations, which is crucial for valuation, due diligence, and working capital efficiency analysis.
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.