Return On Working Capital Method

Return on Working Capital (ROWC) is a method of increasing enterprise value by maximizing efficiency of working capital. Every dollar of EBITDA added to the bottom line is worth five or more dollars to investors in enterprise value. Working capital efficiency has direct affect on EBITDA. Therefore, maximum return on working capital is a key lever to increasing enterprise value.

Every day a company employs a substantial amount of working capital in operations. Before any additional new capital is invested toward growth, it’s important to ensure that return on working capital already invested has been maximized. After all, the cheapest form of capital is internally generated cash flow. The ROWC method ensures maximum efficiency of working capital invested, and consists of two steps:

1. Measure Current Return On Working Capital.
When shareholders invest in a company, they are looking to maximize returns on invested capital. And, like in a mutual fund, where total return is based upon returns on each individual security in the portfolio, the return on the business is the sum of the returns on all activities within the business.

Every business is in the same meta-business - customer acquisition business. Each company has one or more processes for identifying, acquiring, growing, and retaining customers. Therefore, every business should know the cost of acquiring a customer, cost of supporting a customer, customer lifetime value, and associated return.

Return On Working Capital (ROWC) measures returns within the business. How are returns within the business calculated? Every business activity within a company has a discrete investment (expenses) and a discrete return associated with it. Comparing working capital deployed to an activity with the contribution margin it produces gives the yield for each activity. These individual yields cumulatively create the return on the company itself, and usually reveal significant opportunities to reallocate working capital and create EBITDA gains.

The ROWC statement shows if there is a discrepancy between working capital allocated to an activity and its financial returns. The ROWC statement: (1) Groups expenses per each customer acquisition activity they drive. (2) Calculates expected future cash flows from a new customer, based on past and current behavior or on existing customers. (3) Calculates customer acquisition cost and lifetime value per each activity. (4) Calculates yield per each activity.

Example from ROWC Statement:

In this example from a manufacturing company, about $1MM per year is invested in three customer acquisition activities, but each activity produces substantially different returns for the business. The company is over-invested in Trade Shows, which is producing mediocre results, while direct mail and trade publications are substantial contributors. Shifting working capital away from the underperforming activity and favoring the two strong performers will allow for a substantial EBITDA enhancement, without any increase in working capital.

2. Reallocate Working Capital Based on Yields.

Working capital reallocations to activities with higher returns, and reduction of expenses on activities that produce lower returns result in EBITDA improvements. Knowing yield per each activity is crucial to decision making. Without first understanding the relationship between expenses and the yields they produce for the business, cutting expenses can cut growth, or worse, send the business into a tailspin if a particularly profitable process was trimmed.Yield data answers the following questions:

(1) Which activities are critical to the business, and which are not producing desired returns.
(2) Which expenses can be cut with minimum affect on the business?
(3) Is majority of working capital allocated to activities with higher yields?
(4) How much working capital do activities with lower yields absorb?
(5) Can some capital be reallocated to activities with higher yields to increase revenue?
(6) Which sales and marketing activities shall get more working capital?

Working capital allocations and efficiency has direct affect on EBITDA and, therefore, enterprise value. Measuring yields, reallocating capital to activities with higher yields that result in best customer economics, and decreasing expenses on non-crucial activities are at the core of enterprise value creation.