Using Inventory Velocity to Understand Profitability in eCommerce
Your Balance Sheet includes your assets, liabilities, and equity. It provides a snapshot of what you own and what you owe. By looking at the Balance Sheet, you can deduce whether the company has a positive net worth, or whether it can pay its current obligations. Together with two other fundamental financial instruments, it can be used to form financial ratios and conduct financial analysis.
One metric you should take note of is the Return on Working Capital (ROWC) otherwise called Return on Working Capital or Return on Inventory Investment. It can be calculated by multiplying profit margin to inventory turnover. It means the more you sell your inventory, the more you can reuse the capital in a year to gain income.
Return on Working Capital
eCommerce is a capital-intense model, which means cash is the biggest driving force, you need a large chunk of cash to buy inventory months before they are sold for profit. Inventory movement will be the main factor for your financial success or failure.
The ROWC metric will help you understand what happens to every $1 you invest into your business. The result of the metric will tell you if your business is healthy and even shed light on how risky it is.
Computing the ROWC
There are two formulas you can apply when calculating for the ROWC, the first is to assess your current position and the second applies to problem-solving.
The first one is pretty straightforward, you take your Post Advertising Gross (PAG) Profit and divide it by the Average 2020 Inventory Balance. If you have a PAG of $600,000 and an Average Inventory of $200,000, it will give you a ROWC of 3. This means you can reinvest the same capital 3 times in the year.
The second formula involves multiplying Return on Inventory Investment by Annual Inventory Turnovers.
Return on Inventory Investment (ROII) = PAG / Cost of Goods Sold (COGS)
Annual Inventory Turnovers = COGS / 12
It helps to think of these two formulas as two factors, first, one of profit, and the second, inventory velocity. The second formula allows for a more detailed analysis of your ROWC number. It provides insight into problem areas. By breaking down the formula into more specific data, you can identify if your problem is in the profit margins or the supply chain.
Take another business as an example:
Ave. Inventory: 29,500
From these figures, we can calculate:
PAG = 17,000 / 110,000 = 15%
ROII = 17,000 / 68,000 = 25%
Turnover: = 68,000 / 29,500 = 2.3
Using the first formula, we can easily compute the ROWC as 0.58 (17,000 / 29,500). This is a pretty low number, for every dollar you put into the business you are only able to return $0.58.
Now, Applying the second formula, we can see whether the problem lies in the profit margins or inventory turnover, maybe you are not selling your products fast enough. This business’ turnover is at twice a year, which is not that bad, but profit margins are only at 15%, not a very good margin.
To fix this you can try and increase your PAG by renegotiating terms with suppliers or look for suppliers with cheaper options, or revisit expenses such as advertising.
Fixing your ROWC
If you need some help in applying these financial ratios to your own business, don’t hesitate to call us. There is no universal way to improve financial health but meaningful conversations will get you there.