One of the most important questions to ask oneself as a business owner or investor is how profitable his firm is at turning $1 of invested (or borrowed) money into profit.
In this post, we will explain why we believe inventory velocity is a critical to Increase profitability.
Return on Working Capital
This is the most straightforward approach to evaluate a company’s health.
Ecommerce is a capital-intensive business model that requires significant amounts of money to acquire inventory months before it is sold and may result in profits.
For most vendors, making larger inventory investment decisions may be a make-or-break situation.
The measure of how successfully an eCommerce firm makes a profit is ROWC, or Return on Working Capital.
This makes it similar to ROI, but we’ve given it a different name in this instance to emphasize 2 points:
- We’d want to look at something on a yearly basis.
- We’d like to concentrate on inventory.
The objective of this statistic is to assist you in determining what occurs when you put $1 into your firm by purchasing goods.
Ideally, you’ll get your money back as well as a profit or return.
The amount of money you’ll get back, as well as the ROWC value, indicates whether your company is healthy and how risky your capital position is.
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Profit is one aspect of success that this metric takes into account. The aim is to quantify profit multiplied by the number of times your inventory rotates.
ROWC = Profit x Velocity
The more times you may reuse the same money each year to make profit, the faster you can sell your inventory.
There are two methods for obtaining your ROWC number.
The first is simple to compute, while the second requires more effort but provides greater insight into how to repair something if it’s faulty.
You’ll generally begin with the first formula to see where you currently stand.
If there is a problem to be addressed, you can dig deeper with the second formula.
ROWC Formula 1: The Simple Way
ROWC = Annual PAG (in $, not percent)/Avg Inventory Value.
The calculation is as simple as dividing income by inventory.
Consider the following scenario:
To calculate her cost of capital, we simply divide Amy’s 12-month PAG ($600,000) by her Average Inventory Balance for the same period ($200,000).
600,000/200,000 give us a ROWC of 3 – meaning Amy can reinvest the same capital three times during the year.
This is a decent amount. Amy’s company appears to be doing well.
ROWC Formula 2: A Complete Diagnosis
In this second formula, we define our two variables (profit & velocity) as follows:
Profit: Take your last 12-month PAG$/Product COGS. ROII is calculated by dividing your PAG$/Product COGS in the previous year by the current year’s sales per item.
Velocity: COGS divided by COG = Annual Inventory Turns. (COGs divided by COG = average inventory balance)
Keep in mind: Average Inventory is used for the trailing 12 months as opposed to just current inventory because most sellers are increasing at a rapid pace, and comparing current inventory to prior revenue does not always give an accurate ROWC.
If a firm has been stable for the previous year, average Inventory equals current inventory, however if your business is in a growth period, make sure to use an average number.
You may use this second approach to calculate ROWC using the formula Profit and Velocity.
You make a profit whenever you sell an item, but because more rapid items allow you to profit several times each year with the same money,
The advantage of this approach is that it can provide us with straightforward insights into the source of our problem if ROWC isn’t a happy number.
It’s much easier to determine whether an issue is with your margins, a supply chain problem, or if your items aren’t moving quickly enough once you break down the formula into more precise components of data.
Let’s look at a firm that is only just getting started.
The firm produced $170,000 in sales during the previous year and his usual inventory balance was $295,000.
So his ROWC = 170k/295k.
This implies he gets his money back plus 58 cents for every dollar invested (or borrowed) in his inventory, compared to Amy’s 3.0.
If we take the time to calculate PAG% and Annual Inventory Turns, we can discover that Just the firm has poor margins after ads and a sluggish-moving product.
In this example, it would be worthwhile to resolve his PAG by renegotiating supply chains and using his ad dollars more wisely before addressing his inventory velocity, since a money problem is frequently easier to repair than a product issue.
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