Definition
Adjusted Working Capital is a measure of a company’s operating liquidity and short-term financial health. It is calculated by subtracting a company’s current liabilities from its current assets, excluding any cash and cash equivalents. The model allows evaluation of operational efficiency and shows how effectively a company manages its short-term monetary obligations.
Key Takeaways
- Adjusted Working Capital is a measure used to evaluate a company’s efficiency and its short-term financial health. It gives an accurate picture by considering the cash inflow and outflow of a company.
- This financial metric is calculated by adjusting the current working capital by any tax implications, non-cash items and any other adjustments. The formula usually involves subtracting current liabilities (excluding any interest-bearing liabilities) from current assets.
- Having a positive Adjusted Working Capital is seen as a sign of financial strength and liquidity; it indicates that a company is capable of covering its short-term debts, liabilities and operational expenses with the assets readily available.
Importance
The finance term “Adjusted Working Capital” is significant as it provides a more accurate and detailed picture of a company’s short-term financial health and operational efficiency.
It is calculated by adjusting current assets and current liabilities for items that cannot be quickly converted to cash (such as prepaid expenses) or represent future obligations rather than current ones (like deferred taxes), thus emphasizing a company’s liquid assets against its due obligations.
By evaluating the adjusted working capital, investors and management can better understand the company’s ability to cover its current liabilities using its most liquid assets, making it a vital tool in assessing liquidity risk, operational efficiency and the overall financial strength of a company.
Explanation
The purpose of Adjusted Working Capital is paramount to financial analysis in businesses and financial institutions. It is utilized in order to get a far more accurate measure of a company’s short-term liquidity and operational efficiency, by excluding cash and debts which typically fluctuates constantly. Simply put, it offers a clearer picture of a business’ assets and liabilities that are directly tied to its daily operations.
Often, for businesses with larger amounts of cash reserves or significant short-term borrowing, the normal method of calculating working capital might lead to distortions. Hence, in such cases, adjusted working capital comes in handy. Furthermore, adjusted working capital is used when businesses or financial institutions want to remove short-term, low-risk factors that might otherwise distort the working capital computation.
This tool provides a clearer understanding of the operating cycle funds tied up in receivables and inventories and the short-term funds invested in payables. It, therefore, gives insights into the management’s efficacy in managing their operational assets and liabilities, a crucial factor for investors and creditors. Consequently, businesses often try to maintain positive adjusted working capital to ensure they have sufficient liquid resources to support their ongoing activities and growth.
Examples of Adjusted Working Capital
Manufacturing Industry: Let’s consider a car manufacturing company. To calculate the Adjusted Working Capital, the company would need to take into account its current assets (like cash, inventory of raw materials, and cars that are ready to sell), minus its liabilities (like accounts payable to parts suppliers). If the company has a new investment in equipment, such as an updated assembly line, this would also be considered as a capital increase and need to be adjusted in the calculation of working capital.
Retail Industry: In the case of a large retail chain, let’s say Walmart, adjusted working capital would include cash in hand, inventory in the stores, and accounts receivable from customers’ credit card purchases, minus accounts payable to product suppliers and wages payable to employees. They may also adjust for the seasonal variations i.e. increase in stock during holiday seasons or back-to-school seasons.
Technology Industry: A company like Apple, which has cash reserves, inventories of products like iPhones and MacBooks, and accounts receivable, also has accounts payable, accrued expenses and other liabilities which need to be deducted to calculate working capital. But the company may also adjust for the introduction of a new product line which causes an increase in inventory and accounts receivable, thus affecting the working capital.
FAQs about Adjusted Working Capital
What is Adjusted Working Capital?
Adjusted Working Capital is a financial measure that calculates the liquidity position of a company by subtracting its current liabilities from its current assets. It is adjusted to exclude non-operational assets and liabilities, such as cash, cash equivalents, short-term investments, dividends payable, and other similar items.
Why is Adjusted Working Capital important?
Adjusted Working Capital is important because it helps to determine and measure a company’s ability to pay off its short term liabilities with its short term assets. It reveals how well a company can meet its current obligations and run its day-to-day operations without financial strain. In essence, it reveals the financial health of the business.
How is Adjusted Working Capital calculated?
Adjusted Working Capital is calculated by subtracting the current liabilities from the current assets of a company, after adjusting for non-operational cash and cash equivalents and short-term investments.
Is a high Adjusted Working Capital always better?
A high Adjusted Working Capital isn’t always better as it may indicate that the company is not effectively using its assets to generate profits. On the other hand, a low Adjusted Working Capital might suggest that the company is over-leveraged, i.e., it may have difficulty in meeting its current obligations. Hence, it is crucial to find a balance.
Related Entrepreneurship Terms
- Current Liabilities
- Operational Efficiency
- Cash Flow
- Current Assets
- Liquidity Management
Sources for More Information
- Investopedia: This is a premier site that provides news and information about various finance-related topics, including adjusted working capital.
- Corporate Finance Institute: This website offers comprehensive articles and lessons about various financial subjects, including adjusted working capital.
- Accounting Tools: This site has a vast collection of resources and informative articles about accounting and finance, including those on adjusted working capital.
- Wallstreet Mojo: This site offers in-depth tutorials and articles on finance topics, offering resources on concepts like adjusted working capital.
