Running an ecommerce store is difficult because there are so many data points to track. You have to stay on top of customers, orders, inventory levels, marketing, and bills.
As your ecommerce store grows, you can feel strapped for cash. You know that you need to invest in marketing and customer support, but tying up your funds there can make it difficult to order inventory or pay routine bills. Founders know this pain all too much.
We will look at the cash conversion cycle (CCC) and how this formula can show us where our cash is tied up. Understanding and improving CCC can lead to more growth, less dilutive funding, and reduced stress levels.
If you are pressed for time, read the next section only. For a more detailed look and some CCC examples, read all the way to the end.
The Cash Conversion Cycle (CCC) formula is:
Cash Conversion Cycle = Days of Inventory Outstanding + Days of Accounts Receivable Outstanding - Days of Accounts Payable Outstanding
We can simplify this formula to:
CCC = Days Inventory + Days AR - Days AP
CCC is a measure of your efficiency. The lower this number, the better. In fact, it is possible for your ecommerce business to have a negative CCC which means your vendors are actually funding your operations.
Think about that – you can continuously fund your ecommerce store without relying on outside funding from founders, lenders, or equity investors.
To improve your cash conversion cycle, you want to:
As mentioned, there are three inputs into the Cash Conversion Cycle and you have to look at each component individually to understand what to improve.
The CCC formula is days inventoyr plus days AR minus days AP.
All things equal, you want the smallest days inventory, smallest days AR, and largest days AP – which would translate to your vendors funding your business operations.
The table below shows two scenarios for the same ecommerce store. In Scenario A, they have roughly 90 days worth of sales as inventory, 30 days of accounts receivable, and 30 days of accounts payable. These are pretty standard numbers, but, the outcome is not great.
A 100 day cash conversion cycle makes them 25-50x worse than giants like Costco and Walmart.
In Scenario B, the company cut its average inventory in half and extended its payment terms from 30 to 45 days. These two changes alone, without touching AR, made their situation drastically better.
In order to improve AR, we suggest accepting payment at the time of checkout and making sure that your ecommerce platform (e.g., Shopify) pays you out as soon as possible. Some companies have options to pay out less frequently, so be sure to double check.
We would also look at opportunities to have your customers prepay for upcoming products. We go into this topic in more detail below.
The days inventory formula is:
Days Inventory = (Average Inventory / Cost of Goods Sold) x 365 days
We suggest calculating average inventory by adding your daily inventory balance for the last 30 days and dividing by 30. Next, divide average inventory by your cost of goods sold (COGS) for that same period.
It is important that you use COGS because that is cash used to fund the inventory purchase. Do not use revenue when calculating days inventory.
At the end, multiple the value by 365 days to complete the formula. Remember that the correct units for all the calculations on this page is “days”.
You can improve days inventory by, well, holding less inventory. Ecommerce brands need inventory, but it also ties up your cash and creates a problem (if your inventory gets stale).
Getting granular insights into your purchases will help you order the right items in the right quantities.
If you own an apparel ecommerce store, for example, you need to understand the sizing of your customers. Typically, you should follow a bell curve with the bulk of your orders in the middle.
The same principle applies to colors or other varieties. In the beginning, you may order 50 short-sleeved shirts and 50 long-sleeved shirts but as time goes on, you will understand which sells best and adjust accordingly.
Improving your sales and marketing to turn over inventory faster would also help. You should test different price points and promotions to get a balance between quick inventory turnover and a healthy margin.
The days accounts receivable formula is:
Days AR = (Average Accounts Receivable / Revenue) x 365 days
This formula is also called Days Sales Outstanding (DSO).
Divide your average AR by your total revenue for that same 30-day period. It’s very important that your two time periods match. End by converting the formula into days.
You can improve days accounts receivable by collecting revenue from customers sooner. Every day that passes, your accounts receivable (AR) balance is being unproductive. Think of all the uses of that cash – like funding marketing or new hires.
Having customers pay at the time of checkout will reduce your AR balance, thus improving your days AR. Moreover, when possible, we recommend having customers preorder or prepay for products. This simple action will reduce your risk when launching a new product or collection.
Remember that you cannot pay bills with AR! It’s in every founder and business owners best interest to collect cash right away.
The days accounts payable formula is:
Days AP = (Average Accounts Payable / Revenue) x 365 days
This formula is also called Days Payable Outstanding (DPO).
Divide your average AP by your total revenue for that same 30-day period. It’s very important that your two time periods match. End by converting the formula into days.
The biggest points of leverage in this formula is days AP. Stretching AP will allow you to reinvest cash into productive uses. In this case, we recommend making all businesses purchases on a business card. Credit cards automatically extend your credit for your billing cycle.
For example, you may pay bills on June 1st, June 5th, and June 15th. You will not see the cash leave your bank until your statement is due (say, the first week of July). If you can pay your credit card off every billing cycle, you will pay no interest or no fees for this benefit.
Next, look at your largest purchases every month and talk to them about extending your payment terms. Even a change from paying every 30 days to 40-45 days can have a significant impact on cash flow.
Why? Because customers will be purchasing from your ecommerce store every day, and you will be collecting that cash in the interim.
As your store becomes larger and you have more bargaining power, your ability to receive more credit from vendors will grow.
Cash Conversion Cycle (CCC) is an important metric to understanding the viability of your business model. All businesses, including ecommerce stores, need cash to fund operations and growth.
By collecting cash sooner, you are able to grow your operations without taking on dilutive funding or stressing about paying bills. As shown, the best companies have cash conversion cycles that are very, very small or even negative.
In order to reach these targets, you should lower your inventory on hand, lower the time it takes to collect cash (ideally you collect cash at the time of purchase), and negotiate more favorable terms from your vendors.
Track metrics like the top performing ecommerce stores.