Operating with a short capital cycle should be the most important objective of any retailer and online business.
Capital cycle is the time between the disbursement for purchasing a good and the moment when you receive payment for its sale. During the purchase-to-sales process, capital is deployed to pay for the product's manufacturing, inspection, freight, customs duties, trucking, storage, advertising, amongst others.
These costs add up until the product is sold. And even after that, you still have to receive the actual cash, which may take weeks to happen (e.g. if your client has paid with a credit card, or if you have sold through a third-party store). Being able to operate with a shorter capital cycle is critical for the success of any business.
Imagine a business with 180 days of capital cycle. Now imagine the same company with 90 days. The second business is able to generate an annual margin 2.4x the size of the first one with the exact same capital deployed.
This is the magic of reducing the working capital ratio.
The calculation is easy. Consider that retail is a machine that uses products to generate margin – you input product on one side and receive costs plus margin on the other. The more you run this machine, the more capital you generate.
Now let’s say you’ve invested $100,000 in inventory and that you operate with a 20% margin. That means you input $100,000 on one side of the "machine", and you receive $120,000 on the other.
Now let’s say you have a 180-day capital cycle, meaning that it takes 180 days for you to run this “machine”. In one year, you will be able to run it twice.
Making the calculations, on the first cycle you would input $100,000 and receive $120,000. And on the second cycle you would input $120,000 and receive $144,000. Your end accumulated margin would be $44,000.
Now let’s say you’re able to reduce your capital cycle in half and now you can run the "machine" four times in a year. On the first cycle you would input $100,000 and receive $120,000; on the second cycle you would input $120,000 andreceive $144,000; on the third cycle you would input $144,000 and receive $172,800; and on the fourth cycle you would input $172,800 and receive $207,360. Your end accumulated margin would be $107,360.
With the exact same capital invested, you would be able to generate 2.4x more margin. That is why capital cycle is so critical in retail.
When thinking about capital cycle management, some things are not negotiable, such as the time that a marketplace takes to transfer the money to your company. But other things can reduce this cycle considerably.
The most obvious one is supply-chain. If you reduce the time from the moment of the purchase until the moment when the product is available for sale, you will automatically reduce capital cycle, since you need less time between the first disbursement and the receipt of the proceeds from sales.
And, by reducing the capital cycle, you have more free capital to invest in your business growth.
Here's an example of a typical sales cycle for a marketplace seller:
- Order inventory from a supplier
- Pay your supplier
- Receive and store your inventory
- Sell the inventory
- Receive cash from your sales deducting all your marketplace fees
Your cash management and how quickly your cash cycle runs will determine how efficient your cash flow is. Then if you look closely at the metrics, you can figure out what's bottlenecking your cash flow.
Three factors play a role in your working capital cycle:
- Time needed to pay your supplier
- Time needed to sell your inventory
- Time needed to receive payment for your sales
It's key to identify which of these areas are negotiable and which need improvement, so that you can reduce working capital cycle.
It's simple – the longer the working capital cycle, the more working capital you'll need to maintain your business operations. So, by keeping your working capital cycle short, you can more easily manage your cash flow. and the cash conversion cycle.
Why Reduce Working Capital Cycle?
The reduction in capital cycle has two major consequences: freeing up trapped capital and generating more margin and profitability.
Think of inventory as a capital storage. Businesses invest capital in their products and this capital is trapped until the day they sell their products.
When you reduce the number of days in your capital cycle, you free up this trapped capital quicker. This means that you need less capital storage to run your business the same exact way.
The beauty of freeing up trapped capital is that you receive profits and grow without having to invest any penny more in the company. By reducing the capital cycle from 180 to 90 days, for example, you free up 90 days of capital that was trapped in inventory.
This freed-up capital can now be reinvested in the company and suddenly you are able to grow more without any extra capital needed. It is the same amount of capital applied wisely.
The second consequence of a shorter capital cycle is generating more margin. As shown in the calculations in the beginning of this text, by reducing your capital cycle from 180 days to 90 days, you’re able to generate 2.4x more margin.
The proper management of this cycle and the combination of lower capital needs with higher margin production is what differentiates a successful company from a struggling one.
Unfortunately, this is easier said than done, and most retail businesses operate with much longer capital cycles than they should. This is why it is critical to monitor the current ratio of days in your working capital cycle as soon as possible.
How to Calculate Your Working Capital Cycle?
As a business owner you handle a large amount of liabilities and it's challenging to make improvements to a systems assets if you're unaware of what's wrong with it.So the first step is to calculate your current working capital cycle.
Understanding the total time between the first payment to your supplier for the manufacturing of the products and the day that you receive the proceeds from the sale of these same products is one of those liabilities.
First, let’s start with the analysis of the time needed to pay your supplier.
For smaller retailers such as the vast majority of marketplace businesses, it is very hard to negotiate better payment terms with the suppliers. But you should definitely try.
Usually, there are two invoices to be paid, there is a downpayment in the start of production, and a balance to be paid after the production is finalized. Many times, it is possible to negotiate a low down payment (15- 20%), and a payment of balance after departure of the vessel. Some times, depending on your leverage with the supplier, it is even possible to negotiate to pay the balance 45-60 days after the departure of the vessel.
Moving on to the second key factor, you need to understand the time needed to receive payment for your sales. Of course, you want this number to be as low as possible, but most of the times it is very hard to impact this factor, as marketplaces, credit cards etc. have fixed assets and preset standard arrangements that are applied to most companies.
Next, it is important to understand the time needed to sell your inventory. This is where there is room for improvement, since supply-chains are usually less efficient than they should
- The advent of technology creates a whole new supply-chain capability for retailers, especially the modern marketplace sellers. We will talk more about this in a bit.
A Use Case Example
Brian is the owner of Tabuki, an online retailer that sells private label products on Amazon’smarketplace.
His current payment arrangement with suppliers is 50% downpayment at start of production and 50% balance upon sailing of vessel, which usually happens 50 days after start of
production. To make the calculation easier, since 50% of the total was paid on day 0 and the other 50% were paid on day 50, let’s consider an average of 25 days for payment to supplier.
After that, products have to be inspected, shipped, customs cleared, labelled and delivered to final destination. Let's say that this whole process takes another 45 days to happen.
Now let's consider that the purchase includes enough products to maintain inventory for 90 days. Using the same principle, the average days that take this inventory to sell out is 45 days (sales start on day 1, and the last product from the batch is sold on day 90).
Amazon pays Brian's company in 15-day cycles.
Tabuki’s capital cycle could be calculated this way:
Production Lead Time (25 days) + Logistics Time (45 days) + Inventory Time (45 days) + Payment (15 Days) = 130 days
What this means is that Brian needs about 130 days of working capital to convert his inventory into free cash flow.
This is a simplified look at how the formula works – in the realworld, it can be a lot more complicated.
What are some ways to reduce working Capital Cycle?
As we mentioned earlier, it is very hard to negotiate production lead time and payment rules.
It is a little easier to reduce logistics time. But the major difference is in the inventory time management.
Reducing a 90-day inventory to a 30-day inventory automatically reduces your capital cycle in 30 days (45 average days to 15 average days). This means that 30 days of trapped cash can be automatically freed up and used in the growth of your business.
But how is it possible to do it?
Those who already sell private label products know that many parts of the supply chain are absolutely inefficient. Factories want to fit you into their schedule and make you a hostage of their priorities.
Then, after production is finished, they want the products out right away, but now the freight forwarder is the one who wants you to fit their priorities. And this vicious cycle goes on and on until the product arrives at the final destination.
There is no incentive for each player to contribute with the other, to go a step beyond to make everything more efficient. And that is why it is imperative to be proactive and be on top of all stages of the process.
More than that: it is absolutely critical to use technology to lead your business decision-making, so that the purchase-to-inventory process can deliver the right product in the right quantity, at the right place, at the right time, and at the right cost.
Let’s take a look at some ways working capital cycle can be reduced:
1. Use a Workflow-Based System
Purchase orders are repetitive processes. A purchase specialist should have the same target as a bowling professional: always throw the ball the same exact way. But, as happens, with bowling, this is a lot harder said than done.
The purchase-to-inventory process involves many different players. These players not only do not have incentives aligned, but they are also disconnected. Systems are not integrated and, many times, there are cultural and language barriers that make the process even harder.
Having a clear workflow defined and managing it through a robust workflow-based system is critical for streamlining the process.
2. Increase the control of your purchase-to-inventory process
Everything in retail takes time. As seen in the examples above, it may take 90 days or more just to have a product ready to be sold.
With so many days in advance, it is very hard to make accurate predictions. So how do we know how many products to deliver where and at what quantity?
Working on making better predictions is very important. But the real secret for having an efficient purchase-to-inventory process lies in adding more re-evaluation checks during the process.
What if that product that is finishing production had sales reduced and now we only need it 30 days later than initially planned? You can probably send it to another country. Or you can store it for some days at origin, which is usually a lot cheaper than storing at destination. Or why not sending the products in a vessel with a longer route, that not onlysaves in storage cost, but is usually less expensive than direct routes?
3. Use data to make educated decisions
To be able to make smart decisions, it is imperative to have a very good data structure that allows you to make educated decisions.
There are many systems in the market that claim to give you access to data. But they are all focused on control. And control is "past". What you want is a system that is focused on the decision-making, which is "future".
A very good example is the inventory level analysis. In control-based systems, you will see that you have 1,000 items in stock. But this information means absolutely nothing if you don’t know how many items you sell per day.
You need a decision-based system, that will show you the days of inventory, instead of the number of items in stock. More than that: a decision-making system will show you that you have X days of stock, that it takes Y days for a product to be manufactured and sent to inventory, and that, therefore, you will run out of stock on a certain date if you do not take action.
This kind of intelligent twist in the paradigms is critical for modern supply-chain management.
4. Make smart investment decisions and partner with technology-focused providers
To achieve the kind of breakthrough listed in the examples above, it is mandatory to have a deep technology focus. And applying technology is not only hard, but also very costly.
Luckily, there are companies that offer good systems that help you manage your purchase orders and your inventory. The problem is that pure software usually adds complexity, since your company has to adapt to it, and your team has to be trained in operating it. It is not rare to see companies installing very expensive software just to learn that their operations have been completely disrupted.
The problem is that each company has its own way of doing things. There is no right or wrong, no standard way of doing business.
So, what you want is a partner who has the technology to support you without disrupting your processes.
5. Let the experts do the job
The solution in many cases is to let the experts do the job.
In their vast majority, retailers did not create their companies because they love to deal with the bureaucratic, slow, disconnected, and complicated matters of supply-chain.
They did not decide to sell products because they like working during the night to deal with international providers, or to be on top of the times the vessels will depart, or even call multiple trucking companies to try to overcome the delay of a contracted partner.
Let experts do this. They are the ones with knowledge about supply-chain, the ones that already have solutions and all the infra-structure in place to make the needed adjustments. They have teams in multiple locations already connected with the main providers. In other words, they know how to do the job.
At Flieber, we have developed a workflow-based system that integrates the different links in the supply-chain. From the moment of the purchase to the moment of the arrival of the goods at its final inventory destination, our system generates alerts at every point of interaction, so that our clients can choose the best option.
These options are fed by a robust decision-making structure that combines data from different sources to provide intelligent suggestions. The result is a streamlined process that reduces the supply chain costs, the product-to-inventory time and, most of all, the capital cycle of the products.
Having the right product, at the right time, at the right place, in the right quantity, with the right quality, and at the right cost is magic for retail companies. Flieber helps you get there.