Successful ecommerce operators know that operational advantages are just as important as product or marketing advantages when it comes to scaling their business. One such metric to keep an eye on is your “Cash Conversion Cycle”: a measure of how many days it takes for a business to turn invested cash (usually purchased inventory) back into cash in its bank account. This is typically measured as: Days Inventory + (Days Accounts Receivable – Days Accounts Payable). But let’s step beyond the formulas and make this real – these recent financial statements from an international apparel brand shared by Jay Vasantharajh are illustrative of why this metric is so important:
For some more context, here’s the same brand’s income statement:
One of the structural disadvantages of a product business versus a software/service business is the cash required to constantly reinvest in the business. But in this specific instance – and note, it’s a brand that has raised no venture capital financing – you’ll notice that they somehow managed to keep £53M on hand, with £176M in sales in the year. As a rapidly growing ecommerce brand, that cash pile is somehow nearly 4x their after-tax profits for 2019! They got here through a “Negative Cash Conversion Cycle”.
As you’re scaling your ecommerce business, while paying for acquisition costs (that often don’t recoup after several reorders from customers), and incrementally placing bigger and bigger inventory orders, it’s normal to see a strain on your cash reserves. Most brands have a 40-100 day cash conversion cycle, which means that if you’re selling £3k a day you could have up to £300k of cash stuck in operations instead of in your bank account. A negative cash conversion cycle, however, means that your vendors finance your operations – you’re given more time to pay your bills than it takes for you to sell the inventory. There are three levers to pull to reach a negative cash conversion cycle.
The easiest way to achieve a negative cash conversion cycle is to increase the terms of payment on all of your inventory orders. Although most ecommerce brands begin with 15-30 day terms, as you build trust with your suppliers it makes sense to continue to extend this timeline. The brand in the examples above eventually reached a 163-day payment term. When combined with accurate inventory forecasting, you can quickly see how a brand would be able to turn over its inventory long before the payment for it is due. Instant cash on hand.
Direct-to-consumer businesses typically don’t have a significant Accounts Receivable line item because they don’t offer net terms to their buyers. That being said, there are still two ways you can reduce AR to become a negative value: pre-orders (which allows you to collect cash before inventory is purchased or created) and annual subscriptions (if your brand is in a product category that allows this, because you’re able to collect the cash up-front for future product deliveries).
As your brand scales and you introduce more SKUs that have varying turnover rates, it can become increasingly difficult to project how much inventory you should order per product. That being said, if you’re able to reduce the amount of SKUs you hold, increase the manufacturing+shipping time from your supplier, or accurately project inventory needs based on historical SKU-level results, you’re able to minimize the cash you have tied up in inventory in hand.
It’s often “sexier” to scale your acquisition strategies and product strategies than it is to focus on your financial management strategies, but effective ecommerce operators know that optimizing for cash-on-hand can often be the difference between life or death. This is especially true as acquisition costs rise and payback timelines on first-time buyers continue to get longer and longer. Whether you’re building your business towards an exit or into a consistent cash machine, every growing ecommerce business needs to take a hard look at their cash conversion cycle and pull the levers to drive it as low as possible. Cash really is king.
Hopefully, this has given you some insight into how you can measure and optimise your cash conversion cycle regularly. If you’d like to speak to our team of experts for further advice on how to scale your ecommerce strore get in touch today!