Cash Conscious: E-Commerce - Part 2
Updated: Jan 21
The Intro
Welcome back to Cash Conscious! In our first instalment, we identified correct and timely financial information as the first pain point of the cash flow management process. Need a refresher? Find the article here.
Now that we have committed to keeping our finances up-to-date, we can use it to see and address further pain points. In Part 2, we will look at the cash conversion cycle and pull apart what it means to understand in what areas we can fix a poor cash conversion cycle.
You may have noticed the word "cash" in cash conversion cycle. Yup, you guessed it, this cycle will be critical for cash flow management. Without further ado, let's dive in.
The Cash Conversion Cycle
What is the cash conversion cycle (CCC)? Some of you may be familiar with the term, or maybe you have already spent some time analyzing your own! For the rest, let's break this down in simple terms:
CCC = the timing gap between when you collect cash from your customers and when you have to pay that cash to your suppliers.
Are you interested in the detailed CCC calculation? Check out this article here to see it. Madhuri Thakur breaks it down and provides examples with Excel snapshots. It looks excellent, Madhuri!
Why does the CCC matter? Well, a shorter CCC is generally better. It means you recover the dollar spent on inventory and the associated profit margin on that inventory quicker.
A longer CCC means your business needs to finance those extra days until you receive payment from your customer. Those additional days that require financing come at a cost to your business! For example, if you use a line of credit, you must pay the bank interest for each extra day you borrow the money.
Healthy Cash Flow Conversion Cycle
Ok, now that we know what the CCC is, let's discuss a healthy CCC. Above, we identified that a shorter CCC is generally better. However, this does not mean you cannot do business with a longer CCC. The key to a healthy CCC is:
1. Predictability of CCC.
2. Your business's ability to finance the CCC gap.
3. Unit margin after costs of financing the gap.
Predictability is the number one indicator of a healthy CCC. Without predictability, it is hard to calculate 2 and 3. A predictable CCC also helps with future inventory and cash flow planning. Understanding when your business will have the cash to pay its bills make supplier relationships much more manageable.
Ok, so you have a longer CCC gap. There may be options to finance that gap. Bank's offer lines of credit or a financier may provide you margin against the value of the inventory. These options will come at an interest cost, and you must pass the bank/financiers credit application requirements.
Another way to finance the gap is with profits from your past operations. This may result in lower returns for you as a business owner in the short term, but the reinvestment will be beneficial long term if it is profitable. Since you will be foregoing returns in the short term, this is a cost of the financing. It may be easily measurable because you will need to borrow personally. Or subjective because it is an opportunity cost since you could have made a higher return on that money elsewhere.
There is always a cost to financing the CCC gap, whether easily measured or subjective. It is imperative to consider this cost when calculating your unit economics. The financing cost will reduce your margin. If that reduced margin is unacceptable, you will need to address price, input costs or the CCC to make the necessary improvement. You could manage all three or a combination, but for the scope of this series, we will stick strictly to the CCC.
Pain Point 2 - Poor Cash Conversion Cycles
Uhoh... You have calculated your CCC and realize that your unit margins are not what you expected! What now?
As pointed out in Madhuri's calculation, there are three main components to the CCC calculation:
1. Days inventory outstanding
2. Days sales outstanding
3. Days payables outstanding
Each of these topics we will dive into further and explore how we can improve the CCC as Cash Conscious continues in the coming weeks.
Bonus
Above, we focused on CCC's that were positive. I.e. your business paid suppliers before vendors. A positive CCC is a likely scenario for e-commerce businesses.
There are situations where the CCC can be negative. Yes, you get paid before you have to pay suppliers! A negative allows for business growth financed by suppliers at virtually no cost! This is optimal if your business has a profitable product or idea.
Fun fact:
I worked with a team on the sell-side of an acquisition where we proved negative CCC. It created a significant working capital adjustment at the time of sale and resulted in our clients getting more for their business!
In Conclusion
In Part 2, we discussed the cash conversion cycle and what makes it healthy and outlined factors that lead to pain point 2, a poor CCC.
We will look at solutions to a poor CCC in the coming weeks and how they integrate with cash flow management.
About the Author
Nick is a cash management specialist in the e-commerce industry. He helps business owners eliminate uncertainty by developing efficient cash flow management systems. Contact him at 250-885-3088 or nick@razorcon.co to reduce your cash stress.