Why the Cash Conversion Cycle Means Growth or Death for Your Ecommerce Business

What is the Cash Conversion Cycle (CCC), and why is it so crucial for your eCommerce business?

The CCC is the average number of days between paying suppliers for inventory, and receiving cash from customers. 

It has 3 main stages:

• Procuring inventory on credit with invoice payment terms
• Selling the inventory and collecting payment from customers
• Paying your vendor for the inventory
  

In other words, it tells you the health of your cash flow, summarized by the CCC metric.

The Cash Conversion Cycle formula

CCC = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payable Outstanding (DPO) 

• DIO is the average number of days it takes you to sell inventory
• DSO is the average number days it takes to receive cash from sales
• DPO is the average number of days you have to pay your vendors for the inventory
  

The metric you’ll get is how many days there are on average between paying for inventory and receiving the sales revenue. That tells you how well you manage your cash flow. 

The first part of the equation is your operating cycle, which is the number of days to sell the inventory and collect cash from accounts receivable.

Operating Cycle = Days to sell inventory + Days Sales Outstanding

Here’s a quick example of calculating the CCC, and a breakdown for calculating your inputs.

Say (on average) you have to pay your vendors for inventory 15 days after buying it, and it takes 35 days to sell the inventory, then another 2 days for payment to process after customers purchase it. Your CCC value would be 22, meaning you have 22 days between cash going out before it comes back in.

Days to sell inventory (DIO): 35

Days to receive sales cash (DSO): 2

Days to pay for inventory (DPO): 15

CCC = 35 + 2 - 15 = 22 days

To calculate your 3 CCC input metrics:

• DIO = Average inventory / Cost of Goods Sold (COGS) x No. of days
• DSO = Accounts receivable x No. of days / Total credit sales
• DPO = Accounts payable x No. of days / COGS
  

Why Is the Cash Conversion Cycle an Issue for Many eCommerce Brands?

Your cash flow management will determine how soon you can buy more inventory, and how well equipped you are to weather unexpected costs, delays or sales slumps.

The larger your CCC metric, the more time your business needs to be able to finance itself. There will be less cash on hand at any given time for sustaining the business and investing in growth.

It’s very easy for eCommerce startups to get swept up in the intoxication of rapid growth without fully considering the implications of stabilizing their CCC first. More often than not, it leads to:

Cash Flow Problems

If you have short payable terms, extended receivables, or a longer operating cycle, your business can quickly get into difficulty. Your costs and overheads won’t wait until you’ve got the cash. It’s a really stressful position to be in when you don’t have the money you need to stay afloat. Assuming you don’t have piles of personal cash or generous relatives, you can be faced with having to try and secure expensive external finance quickly, or maybe even closing your business.

Inventory Challenges

‍With cash flow issues come inventory challenges. Depending on the length of your CCC, you might find your business unable to pay for more inventory to fulfill new orders coming in. Businesses that can’t consistently and quickly fulfill their orders don’t tend to retain customers! That’s going to have knock on effects for your marketing budget requirements; as we know, winning new customers is more expensive than retaining existing ones. You also risk a barrage of negative customer reviews.

Having To Pay Down for Inventory

‍ If you can’t honor the payment terms with your suppliers, you may find your account blocked until outstanding money is paid and having to pay in full upfront going forward. That can have a disadvantageous impact on your future cash flow, and potentially your business credit score too. 

To sum it up, an unhealthy cash flow that’s not sufficiently corrected will invariably become a downward tailspin that’s hard to pull out of. No matter what great profit margin you’re getting, cash locked up in unsold inventory or a large Accounts Receivable balance for too long can kill your business.

On the other hand, more available cash means you can invest more into marketing and drive down your DIO to improve CCC further.

The Most Savvy Operators Have a Negative CCC

Most eCommerce businesses have a CCC of 40 - 100 Days. However, maintaining a negative CCC is how the most successful and long-lasting eCommerce businesses operate. 

With negative CCC, you receive the sales cash before you have to pay out for the inventory. It means that no finance needs to be injected into these businesses for them to grow.

Negative CCC is typically achieved by: 

• Negotiating generous payment terms with suppliers. Businesses who have more time to pay for inventory than the length of their operating cycle are actually getting their suppliers to finance their business for free!
  

• Having customers pay upfront for a product not yet procured. There are a few methods we’ll touch on shortly.

If we look at one of the best examples out there, Amazon consistency stays in negative working capital position with an average CCC of -13.28 days between 2009 and 2020. Having invested heavily in inventory and distribution management technology, they maintain a low DIO alongside favorable terms with vendors that give them a DPO of 96 days. The secret to their success was having cash available to invest in growth, and particularly for technologically enabling their operations.

Four Tactics To Improve Your CCC

Here are four methods you can use to improve your cash flow and CCC.

1. Increase Accounts Payable

Vendors will decide what payment terms they are comfortable with based on the amount of inventory risk. It’s customary to pay on delivery, or most commonly within 15 - 30 days. However, the more you can negotiate the better.

Naturally, negotiating tends to be easier if you have more purchasing power and place sizable orders regularly, or if you have an established and dependable ordering pattern. Alternatively, you could offer your vendors a slightly bigger profit margin if you can afford it. Your vendors will have their own CCC to be mindful of too, so what’s possible will vary. 

Depending on your business model and available suppliers, we’d encourage you to shop around to achieve the best DPO available. Review your market’s supply chain vendors annually to make sure you’re not missing out on better cash flow opportunities.

The team at Half Past Nine were impressed when we read about Gymshark, who’s annual reporting highlights what’s possible when you’re able to negotiate 163 days payable with your vendors! Nicely done guys.

2. Reduce Accounts Receivable and Product Lead Times

If your business can wait to procure (or manufacture) the product until you’ve already received the sales cash, excellent! This is the ideal scenario, and you’ll benefit from negative lead times and Account Receivable.

Dropshipping, taking pre-orders, batch shipping (ordering from your supplier after you’ve received your weekly orders), or annual membership subscriptions are all means of achieving this.

Dropshipping and weekly batch shipping are most viable when you have manufacturers or distributors located within your target geomarkets and can deliver to your warehouses or customers quickly.

If you need to purchase inventory months out because it takes that long to manufacture or deliver, managing your inventory at optimal levels will be difficult in the fast-paced world of eCommerce. Not unless you offer a very unique product that customers are prepared to wait for!

3. Reduce Your Inventory and DIO

The less inventory you have bought and paid for at any given moment in time, the more cash is available for your business.

It can be tempting to reduce costs by getting one large order shipped over directly from China, or buying a large batch of stock at a discounted price. Reducing costs with bulk orders or shipping can seem like a sensible strategy at first glance, but please check in with your operating cycle and CCC first, because you could be creating a serious cash flow risk for your business.

If you use a local supplier, start bulk shipping by asking suppliers to set aside a minimum weekly inventory for you, and pay when the finalized order is received.

SKU products can often cause CCC problems, with apparel brands being a prime example. If you’re sitting with 100s of SKUs offering multiple size and color options, you’re inevitably going to be holding some of the inventory for long periods of time. If you can’t reduce AR or lead times, try targeting a more niche customer group so you can reduce your SKU inventory, or stop offering the product variations that take the longest to shift.

If you can’t find compatible suppliers to achieve your target CCC, perhaps re-consider the products you are offering. Don’t be shy to cull products that consistently tie up your cash for longer.

Ideally, you can also invest in marketing activity that profitably delivers shorter DIO times. And that leads us nicely into my last recommendation.

4. Focus More on the Cash Multiplier Than LTV

The Cash Multiplier is a great tool for helping you forecast inventory requirements while also improving direct marketing to repeat customers. This costs less than advertising.

Customer LTV is a well-known eCommerce metric. However, it doesn’t tell you the average time between purchases, nor what SKUs attract the highest value customers. It’s actually very important to know what products are most frequently repurchased or up-sold, and in what time interval.

That’s where the Cash Multiplier comes in. The Cash Multiplier is essentially your 60-day LTV. It’s going to help you decide upon a viable CAC that doesn’t negatively impact cash flow in the short-term, and prioritize target audience segments with greater short-term LTV. 

This information will allow you to plan out effective post-sale marketing campaigns in order to extract maximum value from your customers as quickly as possible.

• Half Past Nine has more information on E-Commerce Advertising KPIs: The Advanced Metrics You Should Be Tracking In 2021, which I highly recommend as an essential read.
  

The Bottom Line

Prioritizing your operating cash flow is just as important as your bottom line, especially in the competitive and mercurial landscape of eCommerce and consumer goods. If optimized correctly, it’s a golden goose that unlocks free cash for growth.

Even if your current CCC isn’t threatening the long-term viability of your business, it’s still entirely worthwhile finding incremental improvements where and when you can. What growth-orientated investments would you make in your eCommerce business if you had access to more free cash?

Before you go, check out more of Half Past Nine’s latest growth marketing insights. We specialize in enabling businesses who want to scale rapidly and sustainably!

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