Cash Conversion Cycle: The Metric EVERY Ecommerce Owner Should Understand

Let's start with why the cash conversion cycle matters. Most owners track revenue, some track gross margin, but very few understand their cash flow. The cash conversion cycle answers one simple question. How long does my cash get stuck before it comes back to me?

Think about it, every ecommerce business pre-funds growth. You buy inventory before you sell it. You pay suppliers before customers pay you. You wait on payouts from Shopify and Amazon and wholesalers. The longer the cycle, the more cash you're gonna need. That is why understanding the cash conversion cycle is non-negotiable.

1:02 Days inventory outstanding

At its core, the cash conversion cycle measures the time between paying cash in and getting cash back out. It has three components. Let's look at them.

The first is the days inventory outstanding. This is the most important to understand as an ecommerce business because you have a lot of inventory. Days inventory outstanding answers a key question. How long does inventory sit before it sells?

Now here's how it's calculated. Average inventory divided by cost of goods sold times the number of days you're measuring. If you're measuring for a year, you're gonna do 365. This will get you days inventory outstanding.

Now let's translate that. Take the average value of the inventory you're holding, compare it to how much inventory you sell in a year, and convert it into days.

Long days inventory outstanding comes from a few things. Over buying inventory. Too many SKUs. Long lead times. Slow moving products hiding in bundles. The longer inventory sits in a manufacturing plant, a boat, a truck, or a warehouse, the longer your cash is trapped.

2:03 Days sales outstanding

The second component of the cash conversion cycle is the days sales outstanding. How long does it take to actually receive cash after a sale?

This is calculated by taking accounts receivable divided by revenue times the period you were measuring, in this case a year, or 365.

Let's translate that. How much money do customers or platforms owe compared to how much you sell, converted into days?

In ecommerce, this varies. Shopify typically pays out in two business days, so it's pretty quick. Amazon's a little bit longer. They pay out every two weeks. But you get into wholesale, that could be 30 days, 60 days, 90 days. The moment you add wholesale, that cash pressure jumps.

2:42 Days payable outstanding

The third and final component is your days payable outstanding. That answers the question, how long do I take to pay my suppliers and vendors?

Days payable outstanding is calculated by taking accounts payable divided by cost of goods sold during a period times the days in that period, or in this case, 365 days for a year.

Translated. How much do you owe suppliers compared to how much inventory you sell, converted into days? [unclear], your days payable outstanding will be very low. If you have net terms with your suppliers and vendors, your days payable outstanding increases, which increases your cash flow.

3:16 The full equation

Let's do the full equation. To calculate the cash conversion cycle, I'm going to take the days inventory outstanding plus the days sales outstanding minus the days payable outstanding.

Let's again simplify. How long does inventory sit, how long before you get paid, minus how long you pay your suppliers. That final number, the cash conversion cycle, represents how long your cash gets tied up in a number of days.

3:38 Dell and Costco

Let's do some public examples. When I was in MBA school, we did a case study around cash conversion cycle using Dell.

Dell is known for having a negative cash conversion cycle. That is a thing. How does this work? A customer pays for an order. Dell then starts the order, builds the product, and ships it out. They get paid before they incur any costs for the product. In summary, get paid quickly, [unclear] inventory, negotiate long supplier terms.

Now this works for a big company like Dell because they have great supply chain relationships where they can pay on a deferred basis, and they get paid quickly via credit card from the consumer. Their cash conversion cycle is therefore negative, meaning they're bringing cash in before they have to send cash out. This is an ideal business model and it's really difficult to achieve. You need to be really big, you need to have great relationships with your suppliers, and you need to be able to get paid quickly from your customers.

Another great example is Costco. Costco is known for selling their inventory very quickly, as much as 10 days. And yet, they only pay their suppliers on 30-day terms. So they can turn around and sell the inventory before they even have to pay for it. Meanwhile, they're getting paid by their customers near immediately. Costco's cash conversion cycle is near zero, sometimes a little positive, sometimes a little negative. Again, a brilliant example, very hard to pull off. You gotta sell a lot, you gotta have great terms with your vendors, very difficult to achieve for a small ecommerce seller.

5:06 What we typically see

Let me tell you about what I typically see. I'm typically seeing cash conversion cycles of at least 90 days. Sometimes it can take longer if you have supply chain relationships that are very slow. So if you're selling wholesale and you have terms, or you got to wait to be paid, 90 days is a pretty good number in my experience. I do see brands that sometimes have 180 to 240 days of inventory, and that can add up to a big cash conversion cycle.

The thing about the cash conversion cycle, it doesn't show up on the profit and loss. It doesn't show up on the balance sheet. This is a calculation using both of those financial statements. And thus, you can have profits on your profit and loss if you're using accrual-based accounting and no cash, because it's all tied up.

So when you have long days inventory outstanding, this is where your cash is locked up. Think about it. It's somewhere between the factory and the customer. The longer that cycle is, the longer your cash is tied up.

6:03 What wholesale does to your cycle

Everybody gets excited about going multi-channel. They sign a new relationship with a big wholesaler. They have net 60 day terms. Guess what? Cash gets tied up.

In this case, the days sales outstanding can grow tremendously. You might have a huge purchase order. You can show revenue on the books, but you don't have the cash from selling that inventory because you have terms with your wholesaler. Oftentimes you have increased days inventory outstanding with wholesalers as well, because they need a lot of inventory, and so you got to produce a lot before you push it into that channel.

6:33 How to improve your cycle

Now let's talk about how you can improve your cash conversion cycle, aka your cash flow, without increasing sales.

Number one, negotiate better terms with your suppliers. Manufacturers often have really good lending programs. You could create multiple payment terms. Sometimes you could increase your unit price, slightly decrease your profitability, but increase your cash conversion cycle.

Get rid of bad inventory that's sitting on shelves. Think about it. Inventory that's not selling is cash that you don't have access to. Tighten up your reorder points. No new ad channels, no new sales channels, you're just being more disciplined with cash.

Now another way I like to think about cash conversion cycle is I've got to fund cash somehow to support that cycle. You can do it with profits, but there's a point where your profits aren't gonna fund [unclear]. That number represents the number of days that I'm going to have to finance inventory purchases, or finance purchase orders using factoring or other lending terms where you have sales out but you're waiting for payments to come in.

7:36 Revenue, profit, and survival

Let's summarize. Revenue tells you how big your business is. Profits tell you how healthy your business is. Your cash conversion cycle tells you if you can survive, or tells you what you need to do to survive.

There's the old saying, revenue is vanity, profits are sanity, cash is king. Businesses don't always fail because they're unprofitable, but they definitely fail because they don't have enough cash.

If you found this video useful, like, subscribe, ask me a question in the comments. See you on the next one.