To paraphrase one of the world’s most successful investors, “Revenue is good, but cash is king!”
Cash is easy to measure. You log into your bank account on your phone or computer and can see it instantly. But understanding the levers that control it can determine the success or failure of your business.
Arguably one of the most important financial metrics to understand for a rapidly growing or a low margin business is working capital. And with an economy facing heavy uncertainty as we enter 2023, the importance of working capital increases dramatically with rising interest rates, inflation, and supply chain issues. But like a dog barking at a delivery person, working capital is often misunderstood.
What is working capital in ecommerce?
Ecommerce working capital is used to measure a company’s short-term financial health and the availability of cash to invest in the business. It is calculated by taking current assets minus current liabilities. I learned from someone without any formal business training who ran one of the more successful startups, it was “collecting faster than you pay out and making sure the size of your wallet keeps getting fatter.”
With the markets moving in all directions without a clear course, managing cash flow and liquidity can provide the stability necessary to not only survive, but also to thrive. Working capital improvement is the cheapest form of investment capital for growth, and healthy working capital levels are paramount when trying to raise debt or for mergers and acquisitions.
In today’s blog, we’ll discuss the components, some pitfalls, and ways to improve working capital to keep your business running efficiently.
What are the components of working capital?
First, let’s get the academics out of the way. Working capital is a derivative of the balance sheet.
Working capital = Current Assets minus Current Liabilities
Current Assets = Cash, Accounts Receivable, Inventory, etc.
Current Liabilities = Accounts Payable, Short-term Debt, etc.
Today, we’ll focus on the most important variables, which include Cash, Accounts Receivable, Inventory and Accounts Payable. We’ll discuss the best way to evaluate these metrics to ensure a healthy balance sheet and business.
Imagine you are a brand selling t-shirts with funny phrases (“Sorta tired, kinda hungry, always cold” is a favorite for my wife) that starts to blow up on Instagram. In the first few weeks or months, managing the working capital may be relatively easy. You collect from your customers via credit card and now, with the rising trend, you're also exploring the convenience of accepting payments through mobile wallets (Accounts Receivable), and therefore receive your cash almost instantly. You can then place orders with your suppliers to replenish your inventory. Payment (Accounts Payable) is easy because you already have the cash.
But high growth comes with working capital problems. With growth and order volume, it may take a few weeks or more to replenish shirts in the right size, color, and/or style. And you need to have enough inventory in the right markets to ensure that your site can offer 2-day shipping. Seems like an easy fix, right? Just order more inventory and make sure you can meet the demand. But you still have to pay for that inventory, and now the time to collection (customers ordering and paying you) versus the time you’ve paid your supplier begins to expand, potentially leading to negative working capital. Order and inventory management can reduce the strains on working capital, providing more liquidity to invest in other areas of your business.
We can continue to follow this example down the supply chain. If you’re a third-party logistics (3PL) warehouse serving this t-shirt brand, you may salivate when their inventory and shipping needs increase, as that requires an increasing amount of your services and warehouse space. But this may also require that you expand (services, personnel, and space—warehouse square footage can be seen as analogous to inventory). This expansion means money flowing out (Accounts Payable) of your bank account. And this customer may ask for longer terms because it still needs to sell the inventory coming to your warehouse, which increases your Accounts Receivable balance and the time to replenish your cash.
"Cash is king. Get every drop of cash and hold onto it."
– Jack Welch
What are DSO and DPO?
This leads us to two common metrics utilized to measure working capital efficiency: Days Sales Outstanding (DSO) and Days Payable Outstanding (DPO). These metrics refer to the number of days it takes to collect payment from your customers or pay your suppliers, respectively.
If you are an ecommerce website and only collect via credit card, your DSO will be negligible. However, if you are a 3PL, you may extend 30, 45, or 60-day terms to your customers. And if you only bill 1-2x per month without automated invoicing and payments, your time to collection could easily be 2-3 months after the time from which you provided the services. In short, cash is going out faster than it is coming in. And there is one group that will never accept a late payment: your people and their paychecks.
Therefore, it’s not only important to look at the Accounts Receivables balance, but also how long the receivables are in there. If your business is successful, a growing AR balance can be a positive sign, so long as the time to collect (DSO) is not significantly increasing. However, an expanding DSO is typically an early indicator of the potential for cash flow problems and a deteriorating balance sheet. Managing time to collection should be a focus for both the accounting and account management team. This is also a good check to make sure your customers are remaining solvent and not running into cash flow issues themselves. Connect with the customer via messaging apps for android or video meeting apps and give advice on cash flow issues.
And it works the same on the other side of the balance sheet with Accounts Payable. Days Payable Outstanding, or DPO, is a measure of how long it takes to pay your suppliers. Many companies will stretch payables to suppliers (and sometimes employees). However, this can lead to sour relationships and potentially being cut off until all debts are paid. While stretching payables can help with cash flow management, watching the DPO is another solid metric to measure the health of the business.
In short, there are a few main levers that control the cash flow and investment capabilities of your business (Accounts Receivable, Accounts Payable and Inventory). Mismanagement of these working capital levers can quickly lead to cash flow problems. Even if it appears that you are running efficiently from your income statement (profit and loss), if you are not collecting faster than you are paying out, you are likely to run into a cash crunch.
What are some ways to improve your working capital?
How to improve working capital in an ecommerce business:
- Liquidate excess or slow-moving inventory to free up cash for investment
- Manage orders more efficiently for faster and more accurate fulfillment
- Optimize your demand planning efforts to better manage inventory to align with demand, thereby increasing inventory turnover. This may require additional negotiation upstream with your manufacturers, but can reduce capital tied up in inventory by reducing landed time
- Assess your fulfillment strategies to see if there are opportunities to reduce shipping costs by placing inventory closer to geographies with the highest customer demand and routing orders to a fulfillment center in the nearest shipping zone to the consumer
- Utilize negotiated bulk shipping rates whether directly or through your 3PL partners
- If you offer in-house fulfillment, measure efficiency of your warehouse and personnel with business intelligence tools to decrease bloat and reduce unnecessary spend
- If you have your own warehouses, evaluate whether outsourcing to a 3PL might be more cost effective than the fixed costs associated with your facilities
How to improve working capital in a 3PL:
- Evaluate slower moving inventory and work with customers to either liquidate or move to lower cost overflow storage
- If you have excess capacity in your warehouse, leverage unused warehouse space, consider joining a fourth-party logistics (4PL) network to partner with other growing 3PLs that may need a partner in your geography
- To drive more revenue and reduce barriers to entry in new geographies, acquire more warehouse space virtually by starting your own 4PL with Network Manager and accelerate your geographic expansion opportunities
- Automate invoicing and payments to shorten billing time, increase time to collection and decrease your DSO and time spent by your accounts receivable team
- Reduce shipping costs by utilizing negotiated bulk shipping rates or implementing rate shopping
- Measure and improve efficiency of your warehouse and personnel with business intelligence tools (Labor Analytics)
To learn more about how technology can help you optimize your working capital, schedule a consultation with Extensiv.
