When we talk about working capital in private equity, we may be referring to the financial monitoring value (current assets – current liabilities) or the financial analysis value (current assets – cash – current liabilities).
When monitoring a business, we want to know if it is solvent; that is, whether the business can cover its liabilities. Cash is important in this monitoring because it makes up for any shortfall between assets and liabilities as they fluctuate somewhat independently. If working capital turns negative, we immediately know more cash must be injected to make up the shortfall, otherwise the business is at serious risk of bankruptcy.
However, when conducting financial analysis (rather than monitoring – such as with working capital calculation), we’re interested in understanding how much cash a business needs to support its operations on an apples-vs-apples basis. That means, we must exclude cash when looking at movements in historical working capital because we want to gauge how much cash would have been needed, not how much was actually in the bank. Just imagine, a company could borrow money, raise equity, sell assets, or any other number of things that can move cash and skew historic analysis of working capital. So, we circumvent these aberrations by conducting analysis on an ex-cash basis.