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Return on Working Capital: How to Use Inventory Velocity to Understand and Increase Profitability

Return on Working Capital: How to Use Inventory Velocity to Understand and Increase Profitability

We talk about profitability and P&Ls a lot at Seller Accountant, but equally important is your balance sheet and how it relates to the health of your company. One of the most critical questions a seller or investor can ask is how effective is my business at taking $1 of invested (or borrowed) capital and turning it into profit?

Return on Working Capital (ROWC)

This answer to this question is the simplest way to “grade” the health of a business. E-commerce is a very capital-intensive model, meaning it takes large amounts of cash to buy inventory months before it is sold and can create a profit. Those bigger inventory investment decisions can be make or break decisions for most sellers.

The metric that tells us how efficiently any e-commerce business turns a profit is ROWC or Return on Working Capital. This is basically the same as Return on Capital or Return on Inventory Investment, but in this context we’ve named it ROWC to highlight two things:

  • We want to look on an annual basis.
  • We want to focus on inventory.

The goal of this metric is to help you understand what happens when you put $1 into your business by buying inventory. Ideally, you’ll get your dollar back plus some profit or return. The value of that return or the value of the ROWC tells you whether your business is healthy and how risky your capital situation is.

Calculating ROWC

Broadly speaking, this metric aims to account for more than just profit. The goal is to understand profit multiplied by how often your inventory turns over. Simply put:

ROWC = Profit x Velocity

The quicker you sell your inventory, the more times you get to reuse the same capital each year to generate profit.

There are two ways to arrive at your ROWC number. The first formula is easy to calculate, while the second one requires more work but gives you more insight into how to fix something if it is broken.

Generally, you’ll start with the first formula to assess your current position. Then you can dig deeper with the second formula if there’s a problem to be solved.

ROWC Formula #1: The Easy Way

ROWC = Annual PAG (in $, not percent)/Avg Inventory Value.
In other words, this formula is as simple as dividing profit by inventory.

Let’s look at an example:
Amy's Brand ROWC

Using formula #1 (The Easy Way) all we need is Amy’s 12 month PAG ($600,000) and her Average Inventory Balance for that same 12 months ($200,000). 600,000/200,000 give us a ROWC of 3 – meaning Amy can reinvest the same capital three times during the year. This is a pretty solid number; Amy’s business is in great shape.

ROWC Formula #2: A Detailed Diagnosis

In this second formula, we define our two variables (profit & velocity) as follows:

Profit – Return on Inventory Investment (ROII%). You calculate ROII by taking your PAG$/Product COGS for the last 12 months.

Velocity – Annual Inventory Turns. (12 months COGS$ divided by 12 months = average inventory balance)

(NOTE: We use Average Inventory for the trailing 12 months instead of just using current inventory because most sellers are growing fairly quickly, and often comparing current inventory to old profit doesn’t give an accurate ROWC. If a business has been pretty stable over the past year, then Average Inventory will basically equal current inventory, but be sure to use an average number if your business is in a growth period.)

With this second method of arriving at ROWC, you’ll determine Profit and Velocity and multiply them together. Every time you sell a unit, you make a profit, but faster moving products allow you to use the same dollar to turn a profit several times per year.

The reason this method is more intuitive is that it can give us clear insights into where the problem lies if ROWC is not a happy number. By breaking the formula down into more specific pieces of data, it is easier to see whether the issue is with your margins, if it is a supply chain problem, or if your products aren’t moving quickly enough.

Let’s take a look at a company that is Just Struggling.

Using formula #2, Just Strugglin’s last 12 months of PAG equated $170,000 and his average inventory balance was $295,000. So his ROWC = 170k/295k, or .58. This means for every dollar that he invests (or borrows) for his inventory, he gets his money back plus 58 cents for the entire year – compared to Amy’s 3.0, this is pretty low.

If we do the extra work of calculating the PAG% and Annual Inventory turns, we can see that Just Strugglin has very low margins after ads, as well as a slow-moving product. In his case, it would be worth it to get his PAG in order by renegotiating supply chains and being smart with his ad spending before tackling his inventory velocity, since a spending issue is usually easier to fix than a product issue.

Fixing Your ROWC

By using one of the formulas above to calculate your ROWC, you have a much clearer picture of the health of your business and how to fix it. If you find you need some guidance on how to improve your inventory velocity, increase your PAG, or any other CFO guidance, request a free 15-minute consultation here.

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