Definition of Adjusted Working Capital
Adjusted working capital is the measurement of a company’s operational working capital since it purely considers the operational aspect involved in the business. Similarly, it also removes the liquid and all non-operational components in the business, which are otherwise included.
Technically, it can be seen that adjusted working capital mainly includes all the components that pertain to the sales and the purchases of the company. All other components, including cash and cash equivalents, are not included in the calculation of adjusted working capital.
This is primarily because adjusted working capital attempts to gauge the working capital that a company encircles, owing to its trading (and operational) activities. It does not account for cash. Therefore, all-cash instruments, as well as non-operating liabilities, are eliminated from the calculation.
Explanation of Adjusted Working Capital
In conventional adjusted working capital methodology, the current assets and current liabilities are accounted for. This is regardless of their operational status. This means that whether the heads are operational or not, they are still part of the working capital calculation.
However, there is a shortcoming to this particular approach. As a matter of fact, adjusted working capital does not provide an accurate picture of the operational aspect of the company.
To combat this particular issue, adjusted working capital is designed to remove all liquid and non-operational components away from the working capital calculation. This enables the accountants to inspect the operational aspects of the business in isolation.
The adjusted working capital issue is considered to be in comparison to other metrics. It is mostly used as a proportion of sales on the trend line.
In the case where the sales to adjusted working capital as proportion shows a declining trajectory, this indicates better management practices of the company’s operations. This is because this implies that accounts receivable, as well as inventory investments, are kept low in comparison to sales figures.
Therefore, it can be seen that adjusted working capital mainly includes components related to the business’s operations. All other components that are not related to operations are removed from the working capital calculations.
Calculation of Adjusted Working Capital
Adjusted Working Capital is calculated using the following formula:
Adjusted Working Capital = Accounts Receivables + Inventory – Accounts Payable – Accrued Operating Liabilities
The components mentioned in the formula above are explained below:
- Accounts Receivable: This is the amount that is supposed to be received from customers, as a result of day to day trading activities of the business. This can also be defined as the amount that is likely to be received from the debtors of the company.
- Inventory: are the goods that the company holds for the purpose of reselling. These are physical goods and services that the company owns, and intends to resale it in the forthcoming future.
- Accounts Payable: Accounts Payables are the short-term liabilities or obligations that a company incurs, as a result of purchasing goods and services on credit. Alternatively, this can also be defined as the amount that is payable to the creditors of the business.
- Accrued Operating Liabilities: Accrued Operating Liabilities are general expenses that a business has incurred, but has not yet paid in cash. It must be noted that these are expenses that the company needs to pay, and these expenses pertain to general day to day operations of the business.
The formula above accounts for receivables and payables that pertain to the operational side of the business. It can be noticed in the formula above that it does not account for any liquid components. In the same manner, cash and other marketable securities are not included in the calculation.
Any other current (or short-term) maturities and note payables are not included when calculating adjusted working capital.
All non-operational related liabilities are subtracted so that the actual operational working capital can be calculated as the net amount of liquidity that the business has about operations in the company.
Example of Calculating Adjusted Working Capital
Calculation of adjusted working capital is illustrated in the following example:
At the end of the financial year 31st December 2019, Kyle Co. had the following balances:
- Accounts Receivable: $50,000
- Inventory: $25,000
- Accounts Payable: $20,000
- Accrued Operating Liabilities: $15,000
- Cash and Cash Equivalents: $30,000
Based on the scenario given above, adjusted working capital is calculated as follows:
Adjusted Working Capital = Accounts Receivables + Inventory – Accounts Payable – Accrued Operating Liabilities
Adjusted Working Capital = $50,000 + $25,000 – $20,000 – $15,000 = $40,000
Interpretation of Adjusted Working Capital
Based on the example given above, it can be seen that short-term assets and liabilities are being managed effectively in Kyle Co.
The general rule of thumb when analyzing adjusted working capital is the volume of adjusted working capital generated. Higher adjusted working capital implies better resource management, whereas the contrary suggests otherwise.
Another way of analyzing adjusted working capital is by comparing it to sales. Generally, the proportion of adjusted working capital to sales reflects the trajectory of resource management in a given organization.
If the proportion of adjusted working capital to sales declines, it implies that the operations are being managed with efficiency and effectiveness compared to previous periods.
However, it must be noted that these metrics can only be studied over time to gauge performance. Standalone figures of the sales proportion to adjusted working capital might not render as valuable results.
Advantages of calculating Adjusted Working Capital
From an organization’s perspective, there are several different advantages of calculating average working capital. They are as follows:
- Adjusted working capital helps in analyzing the performance trajectory of the company over the course of time. This is possible if used in conjunction with sales proportion. Hence, this can be used as a metric of performance and efficiency on the part of the managers of a particular company.
- Measurement and subsequent analysis of adjusted working capital helps companies to realize about the utilization of short-term assets, as well as liabilities of the business.
- For cash rich companies, that do not invest excess cash in other investments, adjusted working capital might be able to hint at the financial inefficiency of the company. It might trigger the company to invest their excess cash elsewhere that might be able to generate revenues for them. If normal working capital methodology is utilized, the ratios might not trigger any such reaction, since the outcome of the ratio is most likely to be positive.
Disadvantages of Adjusted Working Capital
Although adjusted working capital provides a resourceful insight for organizations, a few shortfalls need to be accounted for.
These shortfalls mainly lie on the grounds of misleading the company into incorrectly gauging the performing efficiency. During the normal course of business, numerous strategic decisions are taken.
For example, businesses might change credit allowances or credit profiles for some debtors, resulting in an adverse adjusted working capital position. Therefore, it might not be the correct metric for decision-makers to rely on when making these decisions solely.
