What is Adjusted Working Capital?
Adjusted Working Capital refers to the measurement of the business’s operational working capital as it considers only the operational aspect and removes the liquid as well as non-operational items in the businesses, which are considered while measuring the working capital using the traditional measure.
In the traditional method of calculating the working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)", all the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. and current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. of the company are considered, be it the operational or non- operational. Still, it does not provide the correct insight into the business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation.. It fails to provide the exact working status of the company’s operational aspect and how well it is being operated. For this, adjusted working capital is used as this provides the result considering only operational aspects. It does not consider non-operational and liquid aspects. It highlights how well the management of the operations in the company is taking place.
The formula is given below:
Adjusted Working Capital = Accounts Receivable + Inventory – Accounts Payable – Accrued Operating Liabilities
- Accounts receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. are the amount that is due to be received by a business entity from its customers (debtorsDebtorsA debtor is a person or entity that owes money to the other party in a transaction. The receiver is referred to as the creditor, and the payment terms vary for each transaction based on the terms and conditions agreed upon by the parties.) in return for the goods & services provided to them.
- Inventory is the goods that are owned by the company on the given date for further processing (Raw materialRaw MaterialRaw materials inventory is the cost of products in the inventory of the company which has not been used for finished products and work in progress inventory. Raw material inventory is part of inventory cost which is reported under current assets on the balance sheet. and Work in progressWork In ProgressWIP inventory (Work-in-Progress) are goods which are in different stages of production. WIP inventory includes materials released from the inventory for the process but not yet completed. The accounting system accounts for the semi-finished goods in this category.) or sale (finished goods).
- Accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period. are the amount that the entity owes to its suppliers (creditors) for the goods & services.
- Accrued operating liabilities are the expenses of the business that has been incurred but are yet to be paid in cash.
It is to be noticed that while calculation of the adjusted working capital, cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. or marketable securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it., current maturities like notes payableNotes PayableNotes Payable is a promissory note that records the borrower's written promise to the lender for paying up a certain amount, with interest, by a specified date. , a debt payable, etc. are not included.
At the end of financial 2019-20, Amoty Incorporation has the accounts receivable of $ 100,000, Inventory at $50,000, Accounts payable were $60,000, Accrued operating liabilities were $40,000, and cash and cash equivalents were $70,000. Calculate the adjusted working capital of the company for the mentioned period?
Adjusted Working Capital = $ 100,000 + $50,000 – $60,000 – $40,000 = $ 50,000
Here, cash and cash equivalents will not be included in the calculation.
It highlights how short term assets and the liabilities in the company are being utilized to run its operations. Higher the value of the adjusted working capital, the better the utilization of the short term assets and the liabilities.
Also, It can be analyzed with the help of calculating the trend with the proportion of sales. In case there is a decline in the proportion over the period. It indicates that operations are being managed properly. With that trend, we conclude that investment in the inventory and the receivables are kept low concerning the proportion of its sales.
- It helps in analyzing the trend concerning the proportion of sales. With the help of this, management can know various aspects of the business, such as how much investment in the inventory and the receivables are kept to the proportion of its sales, whether there is a high diversion in the trend during any period with the reason for the same, etc.
- This measurement throws light on the utilization of the short-term assets and liabilities of the business.
- This ratio is highly important and useful in companies earning a good amount of profits and retaining the same as cash or investment. This is so because if the company does not use adjusted working capital; rather, it uses the traditional method of calculation of the working capital where all the current assets and liabilities are included. Profit retained as cash or investment will increase the value of the company’s working capital, and the number will also be too high when calculated as the ratio of the sales. This will not show the correct status of the management of the assets and liabilities in the company. Instead, if the adjusted working capital is used, it will show a better picture of the company’s ability to manage the assets and liabilities.
- There are chances that the measurement may give misleading results to the management of the company. For example, seeing the market condition prevailing presently, management decided to increase its customers’ credit period. With this decision, the company’s overall profitability increased, but this will decrease the ratio of adjusted working capital concerning sales in the company, thereby giving a misleading result while analyzing the ratio of adjusted working capital for sales.
Adjusted Working Capital is the measurement that is different from the traditional way of calculating the working capital as it does not include cash and cash equivalents and the current maturities in the business, such as debt payable, note payable, etc. So, this measurement relates purely to operational aspects of business and strips away working capital elements that are not related directly to operations of the company, thereby showing how well the utilization of short term assets and the liabilities are there in the business.
This has been a guide to what is adjusted working capital. Here we discuss its formula, example, and interpretation along with advantages and disadvantages. You may learn more about financing from the following articles –