Cash flow is one of the biggest challenges faced by ecommerce businesses.
There are five key reasons why your business could be eating cash, and addressing these core reasons will do most of the heavy lifting to improve your company’s cash flow and profitability.
Ultimately, your ability to grow is directly correlated to how your books and inventory are managed. In order to grow, you need more stock, but if you hold too much stock, you’ve got cash sitting in your warehouse doing nothing.
Then you need to figure out your margins, which can be eaten up by discounts, returns, Afterpay fees, other merchant fees, shipping costs… the list goes on.
In this guide, we’ll provide five financial tips and tactics to turn your business from a cash-eating monster into a cash-generating machine.
In this article:
- Get your books in order
- Why revenue is a vanity metric
- Know your cash conversion cycle
- Protect your margins as you scale
- Look at your numbers regularly
1. Get your books in order
When assessing the financial performance of your business, you need to know your numbers. However we see a lot of founders not engaging with their numbers the way that they should, and it’s probably because their accounts are not set up correctly.
Most small business accounts are prepared for tax purposes, not commercial purposes.
But forget about accounting as a tool to calculate your taxes – your chart of accounts should be structured in a way that helps you make better decisions from the data.
What your accounts probably look like:
The above graph is a real example of a company’s sales over a 12-month period. They grew their revenue, but their gross profit declined.
What your accounts should look like:
Now that we have more details, we can start to analyse what is actually going on in the business.
For example, the increase in cost of goods sold could indicate some inefficiencies or pricing increases by suppliers. We also now have more visibility over the cost of Buy Now Pay Later fees, high merchant fees, and shipping costs, which all contribute to the decline in gross profit.
Hot tips around how to structure your chart of accounts:
- Ensure all variable costs are treated as Costs of Goods Sold. (i.e. expenses that increase as your sales volume increases, such as Afterpay).
- Split direct vs indirect costs.
- Different sales channels have different profit margins. If you split your profit by sales channel, it will tell a different story.
2. Revenue is a vanity metric. Pay attention to gross profit.
You’ve heard the term “sales fix everything.” But as we’ve seen above, looking at top-line sales alone doesn’t give you visibility on whether or not your products and sales are actually profitable to your business.
What you should be looking at instead is your gross profit. This is the thing that will keep you in business.
Gross profit dollars are more important than revenue because they show the quality of your sales. Do you actually have a good business, or are you just selling products at a heavy discount to grow topline revenue?
To calculate your gross profit, you need to factor in any expense as a direct result of selling your goods, including:
- Cost of Goods sold
- Shipping and delivery costs (including returns!)
- Merchant fees, including Buy Now Pay Later
The best businesses will have strong gross profit margins. Your gross profit margin will vary depending on what you sell (i.e. luxury items vs commodity goods) but a healthy range is between 40% and 60%. Obviously the higher the gross profit margin, the better.
3. Know your cash conversion cycle.
Ever wondered why your profit does not equal your cash? One of the challenges with profitability is that it can be deceiving, because profit is not often correlated with cash flow. What matters more than profitability and revenue is free cash flow.
In the above graph, this company made a net profit of $236,155 but lost $133,845 in cash. How is that possible, you ask?
The cash conversion cycle measures how quickly you’re turning profit into cash. The rule of thumb is, the lower the number of days, the better.
There are three accounts that you need to pay close attention to:
- Accounts Receivable (that’s your B2B payments)
- Inventory (stock sitting in the business, aka CASH)
- Accounts Payable (money owed to suppliers)
You need to measure the amount of days it takes to convert your profit into cash.
How to calculate your cash conversion cycle
Let’s say, on average, it takes 60 days for customers to pay you, 72 days to turnover inventory and 21 days for you to square away payments for suppliers.
Accounts Receivable Days + Inventory Days – Accounts Payable Days
In the above example, your cash flow is being absorbed by inventory for 111 days.
Now the fact is, you don’t get your cash until your customers pay you. The faster you turn your stock, the lower the number of days it sits on your shelf, and the faster you can turn that stock into cash.
Aim for 45 inventory days if you can.
Remember – revenue is vanity, profit is sanity, cash is reality.
4. Protect your margins as you scale
A lot of people talk about scaling and growing, but just because you are getting bigger doesn’t mean you’re becoming more profitable. Sometimes you make less profit as you get bigger.
There are two major hidden costs that can erode your profitability as you scale.
Profit Killer 1: Discounts
Discounting is used by marketers as a way of acquiring new customers. You can discount your way to chase sales volume and topline sales, but the truth is that discounting is the most disruptive lever of your business.
It’s like a drug. It can also destroy your brand over the long term if customers know that you always sell on discount. If you are discounting, use it sparingly if you can.
Profit Killer 2: Return rates
Generous return policies are a killer, because there’s so much more to it than just the direct cost of shipping. Handling returns, repackaging, what to do if you can’t resell returned items – these all cost money and resources.
Some third party merchants such as The Iconic offer generous returns policies, but it’s the retailer (you) who absorbs the cost of shipping, both outbound and inbound. This means you’re paying for postage on goods that you don’t actually sell.
This is why visibility over your sales channels is so important. While partnering with The Iconic might have some benefits such as distribution and brand awareness, financially it’s always best to own your audience.
Make sure you quantify returns and discounts in your Profit & Loss statements.
5. Look at your numbers regularly
Financial success means staying on top of your numbers and reviewing them often.
Manage and maintain your bookkeeping on a weekly basis – not monthly or quarterly. You need to have consistent financial data for tax purposes.
Create a financial budget to forecast cash flow and set timelines for yourself so you have something to work towards.
Discuss your financial position and establish KPIs with your accountant every month.
We also recommend reviewing your sales channels, product mix and pricing strategy every six months to keep on track and make sure you’re heading in the right direction.
These are the things that will help you grow your business in the long term.