Return on Working Capital
Return on Working Capital (ROWC) is a profitability metric that measures how effectively a company is using its working capital to generate profit. Working capital is crucial for daily operations and signifies how well a company manages its short-term financial obligations and assets.
The formula for Return on Working Capital is:
ROWC = EBIT / WorkingCapital
Where:
- EBIT stands for Earnings Before Interest and Taxes.
- WorkingCapital is calculated as:
WorkingCapital = CurrentAssets − CurrentLiabilities
Current Assets typically include cash, accounts receivable, inventory, and other assets expected to be converted to cash or used up within a year. Current Liabilities include accounts payable, short-term debt, and other short-term obligations.
If ROWC is positive and increasing, it may indicate that a company is efficiently generating profits from its working capital. A decreasing ROWC might suggest inefficiencies or potential financial issues. However, as always, context matters: the nature of the industry, seasonal effects, and company-specific factors can all influence the ideal level of ROWC.
Example of the Return on Working Capital
Let’s use a hypothetical example to illustrate the calculation of Return on Working Capital (ROWC):
XYZ Trading Company’s Financial Data (in USD):
- Earnings Before Interest and Taxes (EBIT): $500,000
Current Assets:
- Cash: $100,000
- Accounts Receivable: $300,000
- Inventory: $200,000
Total Current Assets = $100,000 + $300,000 + $200,000 = $600,000
Current Liabilities:
- Accounts Payable: $250,000
- Short-term Debt: $100,000
Total Current Liabilities = $250,000 + $100,000 = $350,000
Now, let’s calculate the Working Capital:
WorkingCapital = CurrentAssets − CurrentLiabilities
Working Capital = $600,000 – $350,000
Working Capital = $250,000
Now, use the ROWC formula:
ROWC = EBIT / WorkingCapital
ROWC = $500,000 / $250,000
ROWC = 2 or 200%
In this example, XYZ Trading Company has a Return on Working Capital of 200%. This means that for every dollar of working capital, the company generates $2 in earnings before interest and taxes.
This might seem exceptionally high, but it’s just a hypothetical example. In reality, ROWC values can vary widely depending on the industry and business model. As always, it’s essential to compare the ROWC with industry benchmarks or historical company data to gauge its effectiveness.
