Cash and working capital
Welcome to Incubateme’s newsletter, curated by Alice Zhang.
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Dear all,
As we delve deeper into running a business, it is important to understand a few key financial metrics, and be able to use those metrics to diagnose and know signs of good business health.
Cash Conversion Cycle (CCC) is one of them. It is an important metric to measure your working capital needs and health. Today we curate an article by Every.io diving into the details of each element of CCC, and how to improve it. It is a bit technical but we hope you could use this to take the pulse of your own cash management situation!
Along with it if you need help on improving your working capital for anticipated growth in operation, please check out our Get Working Capital service and Schedule A Call!
Cash conversion cycle (CCC)
When an eCommerce business starts making more money, it costs more money to run. Consider an apparel business that sells athleisure. A pair of joggers might retail on the company’s website for $100 and cost them $40 to manufacture and ship. The gross margin on the joggers is $60 (60%), leaving that amount for all of the non-unit expenses like corporate salaries, rent & utilities and marketing.
That all makes good sense. But what if you want to start this apparel company from scratch? You would need to pay the manufacturer for those joggers before you sold them to your customers. The income statement describes the profitability of a company, but it doesn’t describe the cash dynamics.
A cash conversion cycle (CCC) is the amount of time it takes for a company to return the cash investment in inventory back to the company. CCC is important because it bridges the gap between profitability and cash flow. A high, positive CCC means that your cash is held up longer in inventory. A negative CCC means the opposite: your suppliers are financing your business for you. At zero interest. It’s highly preferable to have a negative CCC, but it’s hard to do!
In this piece, we’re going to look at the formula for calculating CCC, and go through examples from eCommerce IPOs and startups that demonstrate how to improve CCC—and what to avoid.
Cash Conversion Cycle Formula
To measure the quantitative impact of this dynamic, companies track their cash conversion cycle. The CCC tracks the number of days it takes for a company to return it’s investment in inventory back to themselves. Here is the formula:
Days of Inventory Outstanding
+
Days Sales Outstanding
-
Days Payable Outstanding
=
Cash Conversion CycleDays of Inventory Outstanding (DIO) is the time it takes between when a company buys inventory and when they sell it. If a company’s DIO declines from 20 days to 15 days, that means that the company is selling inventory five days faster. They used to buy on the first of the month and sell it by the 20th, now they buy on the first and sell on the 15th.
Formula: (Average Inventory / Cost of Goods Sold) * 365
Cash Impact: An increase in DIO is a decrease in cash; a decrease in DIO is an increase in cash.Days Sales Outstanding (DSO) is the time it takes before receivables are collected. As an example, an original equipment manufacturer (OEM) like YKK (which manufactures zippers) might sell 10,000 units to an apparel company that makes joggers. These transactions are often bought on credit and invoiced, with terms to pay the supplier afterwards. A common payment term is Net 30—meaning the buyer has 30 days to pay the supplier. However long it takes, the number of days where the buyer has the goods but hasn’t paid the supplier yet is called Days Sales Outstanding.
Formula: (Average Accounts Receivables / Credit Sales) * 365
Cash Impact: An increase in DSO is a decrease in cash; a decrease in DSO is an increase in cash.Days Payable Outstanding (DPO) is the opposite of DSO—it’s the number of days it takes for a company to pay its own bills and invoices to its creditors. In that same example, YKK might buy chemicals and plastics to make their zippers. The amount of days between when YKK gets the supplies and when YKK actually pays their supplier is their DPO.
Formula: (Average Accounts Payables / COGS) * 365
Cash Impact: An increase in DPO is an increase in cash; a decrease in DPO is a decrease in cash.Public Retail IPOs
One interesting way to understand the dynamics of cash conversion cycles is to look at the metric across various types of retail companies.
Below I compiled the CCC of 17 eCommerce and retail companies at the time of their IPO. As you can see, there’s a wide range: the lowest being negative 163.8 (Blue Nile) and the highest being 152.5 (Canada Goose). Let’s dive into a few of them to understand the mechanics.
Blue Nile ($NILE): -163.8. Important Factor: Supplier Relations
Online engagement ring retailer Blue Nile set up their operation to have positive cash flow dynamics. While their main value proposition to customers is the 20-40% discount on diamonds and jewelry, they have a very strong relationship with more than fifty suppliers. Blue Nile doesn’t procure diamonds from their supplier until a customer pays for them, and due to long-term contracts, Blue Nile doesn’t have to pay their suppliers for 30-120 (or more) days. At the time of their IPO, Blue Nile had a Days Payable Outstanding of 261.0, which is what makes their CCC so low.
Wayfair ($W): -84.3. Important Factor: Low Inventory
Wayfair is one of the largest home goods eCommerce players and competes by having great merchandising and one of the largest online selections of goods on the internet. The trick to their negative CCC is their inventory management. Wayfair utilizes an asset-light strategy where over 90% of their items are shipped directly from the manufacturer to the customer. This allows Wayfair to carry very low levels of inventory, thus reducing their cash burden. At 6.0 days, Wayfair has the second-lowest Days of Inventory Outstanding of any of the companies we analyzed.
Canada Goose ($GOOS): 152.5. Important Factor: High Inventory
Canada Goose sells high-end (“Extreme Weather”) outerwear, mostly notably a puffy and warm parka. They had the highest Days of Inventory Outstanding of any of the companies, coming in at 233.2 days (over 7 months!). In 2019, Canada Goose had $738.7 million in sales. But, as you might expect, $345.5 million (46.7%) of those sales came in Q4 while only $54.3 million (7.3%) came in Q2. The product is heavily geared towards cold weather and it’s also popular as a gift. The reason DIO is high in these situations is that it’s harder to predict demand YoY then it is QoQ. If a company sees the demand rising every quarter (or month), it can more accurately predict the next month. But if they are expecting the demand to follow the previous season, it’s much harder, so they have to carry more inventory.
How to Improve Cash Conversion Cycle
Decreasing the cash conversion cycle is one of the best ways to improve your cash position. To dramatically change your CCC you would need to change your whole business model. But there are a couple ways to improve it incrementally.
Reduce inventory by reducing DIO
Reducing inventory is one way you can reduce your cash conversion cycle. There are several ways companies can achieve this:
Improve demand forecasting.
Reduce supplier lead time.
Reduce order cycles.
Promotions and marketing.
Reduce accounts receivable by decreasing DSO
The second way you can reduce your CCC is by reducing your accounts receivable: collect money from your customers faster. With many eCommerce businesses, this one is hard to change because your customers pay with cash already.
Increase accounts payable by increasing DPO
The final way you can decrease your CCC is by increasing your accounts payable balance. This one is a bit counter intuitive: accounts payable is the amount of money you owe to suppliers. Wouldn’t you want to decrease that number, not increase it?
Let’s walk through a quick example. In Period A, you have $10 of inventory. You pay $5 in cash to suppliers right away, and pay $5 later because it’s on credit. In Period B, you still need to buy $10 of inventory, but you increase your accounts payable from $5 to $6. This means you only have to pay $4 in cash to your suppliers right away. So increasing your accounts payable actually increases your cash balance.
So how can you increase accounts payable?
Generally, there are two ways. The first involves a bunch of incremental improvements: building a better relationship with your supplier, using software to automate invoicing and payments, and being more consistent. The other way is to build negotiating power—usually by achieving scale.
Membership models
While the above three sections describe the three ways you can adjust your CCC when running a business, it’s also possible to design a business with positive cash flow dynamics in mind. And one of the best known tools to do that is through a membership model.
The most well-known examples of successful membership models are Amazon and Costco. Amazon is able to leverage their annual Amazon Prime Membership to drive a negative CCC. Costco also adopts a membership model and has had a CCC between 4-7 days (significantly lower than the industry average of ~80). Keep in mind that the negotiating power due to their vast scale also helps them keep a high DPO, which also helps lower their CCC.
So, whether you are an operator or investor, it’s always important to keep your cash conversion cycle on the top of your mind. Managing it properly is the difference between being in control of your cash position and running into liquidity problems.
Every.to
🌟 Announce the pilot launch of Get Working Capital service. Book a free consultation here!
Working capital financing is when a business borrows money to cover relatively small expenses such as day-to-day operations and payroll, when you experience or prepare for rapid growth. If you want to find out your Cash Conversion Cycle and interested in increasing working capital through non-equity funding lease check the details out HERE and SCHEDULE A CALL to figure out if this is right for you!
Featured business: Jibs
Company URL: https://WeAreJibs.com
Location: Miami Beach
Founder: Natalie Kathleen
Founded Year: 2015
Business is about: great on the planet, even better on your feet shoes.
👟 Tell us about yourself, and your company.
The Jibs journey began in southern Brazil in 2015 when I set out to create a fun-loving pair of perfectly perforated, leather sneaker-shoes that would be as kind on the planet as they are on your feet. The effortless combination of a traditional Brazilian beach slip-on with an urban polish means that your Jibs can go wherever your adventures take you.
With biodegrade leather uppers and recycled rubber soles, Jibs are lovingly made with care for the world on which we adventure. True, it costs us more to make a biodegradable leather upper, but we truly believe that taking care of our global neighborhood is the first step in any memory-making adventure.
👟 How did you get the company stared and acquire your first batch of customers?
I was living in New York and went back to my hometown of Vancouver to visit family; at the same weekend a good friend I grew up with, who now lived back in Brazil with his family, was also visiting that weekend. He had brought with him a couple pairs of shoes that his nephew Isaqui had made at their family factory; while at dinner with a group of us he asked who was a size 7 as he had one pair left and that was me!
I then brought the pair back to NYC and swapped out my heels for these perforated sneakers, loving the air flow while riding my bicycle around the hot humid city… tons of people noticed and commented. the gay friends said “those are Brazilian sneakers” as seen them on beaches in Rio. I then whatsapp’ed Isaqui to make a few design updates, to make them unisex in a range of colors and hosted the inaugural rooftop in Chelsea Jibs launch party in August 2015 for pre-order.
With this, the concept and design was super quick to be accepted and people wanted to buy second and third pairs I then jumped on a plane down to Brazil to perfect the Classic, add on the High Top and Slim, and start to find better quality suppliers!
👟 Did your business pivot in the pandemic?
I closed on our first large seed investment in February 2020, immediately flowing into a planned larger than ever scale production in March - and voila with Brazil falling quickly infected. My investor team came solidly on board advising me week over week and we leaned out the business like I never could have imagined - coming into 2021 with stronger roots than ever. We broke down the “hockey stick” projections and built out healthy operations allowing us to build on the brand with more slow and strong growth.
👟 What is your plan for the future? What trends do you foresee for your industry?
Purposeful distribution partners, launching 2021 with ZAPPOS and a big move with price positioning for elasticity now that we’ll have access to a broad national audience and sitting on decent profit margins. Summary of this first action is to find creative ways to reach new (to become addicted) Jibs’ fans with giving them the benefit of best pricing, rather than overspending on fancy marketing tools and advertising. Big challenge that I am excited to tackle!
👟 Any other lessons/advice you’d like to share with other fellow entrepreneurs?
Believe believe believe. Even when it’s tough. Find those key individuals who really have your back and take their advice to heart.
👟 Any requests for help from our community?
Yes! Looking for other female business owners who are two steps ahead of me. Love bouncing ideas off like-minded founder friends and equally thriving to have more experienced advice from someone who’s been there / done that along a similar journey I’m on.
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You made it to the end !
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