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Understanding Cash Conversion Cycle for eCommerce

Does your eCommerce business understand its cash conversion cycle?

The opportunities in eCommerce continue to multiply. A new study shows that by 2025, sales are forecast to grow more than 55% from their 2021 levels. But with great opportunity comes risk. 

The number one reason businesses fail is because of cash flow problems, and for eCommerce businesses, these problems are unique.

The primary issue for eCommerce businesses is that, more often than not, you have to pay for inventory before you collect cash from customers, leaving you at a loss from the very beginning. 

To solve this problem, you have to understand the cash conversion cycle.

Understanding the Cash Conversion Cycle (CCC)

The cash conversion cycle (CCC) measures how many days it takes you to turn the cash you’ve invested in inventory into cash in your bank account. 

The larger the CCC (the longer it takes to sell goods and recover your investment), the more capital you have to pull from your own pocket and into your business.

The Cash Conversion Cycle Formula

CCC is defined as:

CCC = Days of Inventory Outstanding (DIO) = Days Sales Outstanding (DSO) – Days Payables Outstanding (DPO)

In other words, CCC is = 

the number of days it takes you to sell your inventory + the number of days it takes to collect cash from customers – the number of days it takes you to pay your bills.

However, for most eCommerce businesses, receivables aren’t an issue because you get paid when you sell inventory, so a modified version would be something like:

CCC = number of days it takes you to sell your inventory and collect cash – number of days it takes you to pay your bills

Look at how the cash flows in this graphic:

  • A cash outflow happens when you pay for inventory.
  • A cash inflow happens when a customer buys items at your eCommerce store.

This is where cash flow problems start: You have to pay for inventory BEFORE you collect the cash. 

If the lag between paying for inventory and collecting the cash gets too long, you can run out of cash even if you’re successfully selling all of your goods. You may have to dip into your savings or profits to continue to keep the business operating. This can limit your ability to purchase additional inventory and impact future sales.

At the same time, you have other financial considerations including fulfillment and shipping, warehouse and carrying costs, marketing and advertising, and other operating costs – these costs don’t pause just because your cash is tied up in inventory. 

You still have to pay your other bills to stay in business. This can cause you to show a gross profit on paper, but struggle to realize any substantial cash flow from your business.

Correcting the Cash Flow Problem

Most eCommerce businesses have a positive CCC. This means they are following the model above where it takes them too long to convert an inventory purchase into cash. 

The best solution is to buy the inventory and sell it, get paid in your bank account BEFORE you pay your suppliers for the inventory.

This would create a negative CCC which would look like this:

Having a negative CCC ensures you have enough cash in the business at any time. 

So, how do you accomplish a negative CCC? Generally, there are two ways.

  1. Negotiate with your supplier
  2. Use financing

Negotiate with Your Suppliers to Pay Them Later

Instead of paying for your inventory before you collect cash, negotiate for longer payment terms from your suppliers. 

For example, if you can get your suppliers to commit to net 60 on payments for goods and it typically takes you 30 days to sell your products, you’ll have a CCC of minus 30. This means that you have cash in hand for 30 days before you have to pay your suppliers.

This gives you capital to help:

  • Fund your business
  • Collect profits
  • Pay other bills
  • Reinvest in other areas for growth

Depending on your suppliers, this could be difficult. If that’s the case, the second option is to finance your purchase orders.

Use Financing

Get a credit line or another preferred method of financing (like Settle, or ClearCo) to pay for the inventory purchase. 

When you do this, ask for terms that allow you to repay the financing after you collect cash from your customers. This gives you greater flexibility and allows you to repay the financing after you convert the goods you purchased into cash from customers. 

Soon, you’ll see a negative CCC as shown below: 

Need Help Creating a Negative Cash Conversion Cycle?

A negative cash conversion cycle is one of the keys to success for eCommerce businesses. 

It helps with cash flow, ensures you have enough revenue on hand to continue to fund your business without using your own capital, and makes it easier to build a profitable business.

While creating a negative cash conversion cycle sounds simple in theory, it can often be quite complex. Talking to an expert like Vertical CPA can help you reverse your CCC and manage your cash flow more effectively.

Contact Vertical CPA today and let us help you grow your eCommerce business.

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