Understanding Growth Limitations: How Capital Controls Your Ecommerce Expansion

I am Stephen Brown. I am the COO of LedgerGurus. I'm also a co-owner of a direct to consumer brand. I do a lot of our advisory services here.

With me, I have Lauren Maillard. She is our Director of Service Delivery. She launched our income tax practice, helped build our sales tax practice, and is a former small business owner.

We're going to dive right in. Lauren is going to be watching for questions. Feel free to ask questions in there.

0:37 Stephen Brown

So with inventory businesses, faster growth requires more cash. When you think about it, it's really because you pay suppliers for inventory before getting paid. Inventory takes time to sell, wholesale payments can take time to receive, and cash to grow can outpace cash from sales.

So there is actually a mathematical limit to how fast you can grow.

1:03 Stephen Brown

Part of that limit is your profits, right? So if you're self-funding growth, one of your constraining factors is your profit, because that is the fuel that allows you to buy inventory and wait for payments to come in.

1:21 The cash conversion cycle

Stephen Brown

The other limiting factor is this very complex concept called the cash conversion cycle.

So hang with me, because the cash conversion cycle can be a little bit confusing. In fact, when I learned about this in MBA school and went through it, I remember getting down and saying, I never want to do this again. But it's a very important concept to understand. And I'm going to try and break it down in very simple terms, without hopefully confusing it too much.

1:51 Stephen Brown

So basically you put cash out of your bank account and into the machine that is your business. And that usually goes into the form of inventory. So the one way that cash gets tied up is in inventory.

So you go in and you make an order and you have to make your initial down payment. And then maybe you make additional payments. And then eventually it comes across on a boat, or if you're lucky, maybe you're manufacturing, you have to buy raw supplies. And then it goes and it sits on a shelf until it gets sold.

2:26 Stephen Brown

But the cash doesn't come out then. Then there's this concept of days sales outstanding. Now, technically, this would include some of the payout timing, but we don't typically track payouts as accounts receivable. But usually the days sales outstanding is looking at accounts receivable.

So when you're looking at wholesale, you do an invoice and then that invoice goes to accounts receivable, then you wait to get paid on that. For a lot of wholesale accounts, that can be 30, 60, 90 days. We saw in peak COVID, some retailers were saying, we're only going to do six month payouts. And so even though you sold said inventory, that cycle continues to go on for however long it takes you to collect the cash from that sale.

3:13 Stephen Brown

Now there is one area where the cash can go in your favor. So if you can defer payments to your vendors, that shortens that cash conversion cycle.

But the way you have to think about it is, the longer this cycle is, the more cash you need to keep the engine running, because the cash is getting tied up.

3:36 Stephen Brown

Now, the nice thing is it comes out on the other end. You're usually going to have more cash than you put in, right? So you put in a dollar, depending on your gross margins, you may have $2, $3 that come out on the other end. But in the meantime, you've got that money that gets tied up for however many days.

4:19 Calculating it, and why yours may be wrong

Stephen Brown

Now, if you want to know how to calculate this, and it really sucks, like I said, I did this in MBA school and I remember thinking, I never want to do this again. And then I got into LedgerGurus and we started working with ecommerce customers and I said, this is really important. I've got to dust off my brain and do it again.

4:21 Stephen Brown

So here are the calculations. Essentially, these are a mathematical way of looking at these three components. One is looking at average inventory values divided by cost of goods sold. Average accounts receivable divided by total revenue. Average AP, or accounts payable, divided by cost. And the result is, this is how many days are tied up.

4:42 Stephen Brown

And usually when I talk to my customers about this, most of the time, if they're not doing wholesale, the majority, if not the entirety of that number, is in days inventory outstanding.

The business I own, we have a supplier out of Italy. They're very slow. It can take months from order start to completion. And then it's usually a couple of weeks to sometimes a month or two from outbound shipment to receipt in our warehouse. So we have a very large cash conversion cycle and it's really annoying.

5:19 Lauren Maillard

Stephen, where are you calculating this?

5:22 Stephen Brown

Where am I calculating this?

5:25 Lauren Maillard

Yeah. Where are you getting the numbers for this, or where do you calculate this? Is it in the Grow dashboard or do you have an Excel?

5:32 Stephen Brown

I can do it in Excel. I do with some of our customers. We talked about metrics last month. For some of our customers that work with me on advanced advisory, I've got a way to automatically calculate this. It is a little bit intensive to go through these calculations. I'll just put it that way.

5:54 Stephen Brown

Now, the reality is your cash conversion cycle may not be accurately calculated. And let me tell you why.

If you're not tracking your inventory correctly, then your cost of goods sold and your inventory balances are wrong, and your days inventory outstanding will probably be wrong. This is probably the number one issue I see, is bad inventory management, bad inventory tracking equals inaccurate inventory accounting. And therefore I can't give you a good days inventory outstanding.

6:29 Stephen Brown

If you're not doing good timely invoicing and receivables management, you're not going to have good accounts receivable numbers, and therefore that will be hard to do the days sales outstanding.

I see some people, they'll get a bill, they'll just pay it. They treat it like a cash expense. So you don't really have your days payable outstanding. The right way to do it is to put it into your accounting software as a bill, and then you pay off said bill, and the accounting software will keep track of those balances.

6:58 Stephen Brown

So these are reasons why you can't calculate your cash conversion cycle accurately. And the first one is the one I see with almost everybody, including customers we've worked with for a while, because they just can't get their inventory management dialed in.

When I talk to a customer who doesn't have good data, we can estimate what that number is and give us a ballpark range. But I just want to make, if you go to calculate that right now and you're like, that doesn't feel right, it's probably because one of these three things is not being done accurately.

7:31 Working capital intensity

Stephen Brown

Now, with that cash conversion cycle, I can come up with what's called a working capital intensity ratio. Basically, how much of my cash is tied up in working capital.

And different businesses have different working capital intensity. I haven't calculated it for LedgerGurus. We're a services-based business, but I would say this is near zero. I won't say it's zero, but it's near zero. Meaning we don't have a lot of working capital requirements. We typically bill quickly, or sometimes we pre-bill. It makes it so that we have almost no working capital intensity.

8:14 Stephen Brown

For inventory-based businesses, this is completely different. As you can see, I can have two $1 million businesses, and depending on their working capital intensity, they may have much larger requirements, which means I need to have that amount of money available to put into the machine to continue to grow.

How do I calculate that? Go ahead, Lauren.

8:36 Lauren Maillard

Sorry, I'm asking the easy questions for those of us who aren't accountants. I'm representing the non-accountants here. What is working capital? What does it represent?

8:51 Stephen Brown

Working capital represents the amount of cash that gets tied up in that machine, in that cash conversion cycle. It's cash that's not sitting in your bank account. It's cash that's in inventory. It's basically getting consumed by the business to keep running. And in an inventory-based business, that's primarily getting tied up in inventory.

9:20 Stephen Brown

Okay, now this working capital intensity is just a ratio. We take that cash conversion cycle, it's a days number. And if I wanted to annualize it, I would just take the annual cash conversion cycle divided by 365. So that gives me a ratio of what percentage of my revenue is going to get tied up in working capital.

And so I need to have that cash available to run my business. That cash goes out of my bank account, typically into inventory. And the more intense the working capital, the higher amount of money I need.

10:04 Stephen Brown

So where does that money come from, right? Today we're talking about self-funded growth. In a couple of months, we're going to talk a little bit about debt. But essentially, I have to get that money from somewhere. I either have to build it up through profits, or have it injected into the business.

And the faster I grow, the more likely that I am going to exceed my working capital available.

10:44 The self-funded growth rate

Stephen Brown

The self-funded growth rate is very simple, if you can wrap your head around what I've said. So let me summarize it down so you don't have to think about all these calculations.

I have cash from profits and I have a need for working capital. So basically you divide your profit margin by your working capital intensity. And that's going to come up with your maximum growth rate.

11:15 Stephen Brown

So, and this is all mathematical. The reality's a little bit different, I'll talk about that reality.

Essentially, when you run that calculation, it says, this is the maximum growth rate I can accomplish on my own profits. I should put an asterisk in there, because there are some nuances and I'll talk about that in a few slides.

11:37 Stephen Brown

Now why is this important? A lot of people are like, hey, I've got profits, but I have no cash. Yeah, your cash got tied up in inventory.

I have no profits and I have no cash and I'm taking debt. That's because you're growing faster than you can grow from your profits.

12:02 Stephen Brown

And this is an important thing to understand, because it also will dictate how much debt you need. This is another part I'm going to do here in a few months in our expert webinars, to help you understand how exceeding this limitation is going to drive a need for more debt.

12:21 Stephen Brown

So let's give an example. I have my million dollar business. My maximum self-funded growth rate is 14%. So I can get $140,000 in new revenue, get to $1.14 million. Any growth beyond that is going to need outside capital.

And again, I should put an asterisk on this, because there are some scenarios where you could be growing this fast but still need some additional capital.

12:55 Three levers to improve it

Stephen Brown

But before we do that, let's talk about how I can improve my self-funded growth rate. There are essentially a couple of key levers.

One, can I speed up my cash? Can I reduce my days inventory outstanding or reduce days sales outstanding? Easier said than done, right?

13:12 Stephen Brown

Me and my partner at the business that we own, we're like, gosh, how do we speed up? One of the things that we're talking about is, should we start air freighting? Would the cost of air freight be lower than the cost, because we're growing faster than our self-funded growth rate, would it be lower than the cost of lending?

We can shrink the amount of time that we need, because there's about a one to two month cycle once the product's done. So part of it is we're starting to think about maybe we air freight enough inventory to cover the shipment time and we shrink that inventory cycle a little bit. So that's one of the thought processes we're going through.

13:58 Stephen Brown

It's really hard to tell your manufacturer to go faster, right? If you can negotiate terms with your suppliers, that also speeds up the cash cycle, because you're deferring payment.

Other things, so optimizing how much inventory you have, because there's another part of that equation. There's the time from purchase to getting it into the warehouse, but how long is it sitting on the warehouse shelf? Can I shrink that?

14:29 Stephen Brown

The second way you can improve your self-funded growth rate is to improve your profit margin. Easier said than done in the last couple years. We are getting squeezed, squeezed, squeezed.

In fact, I had a conversation with my partner yesterday, and Shopify is raising their rates on payments. Our supplier is increasing their prices for the first time in years. I'm trying to remember, there was one other thing. They weren't big, but they're little. All these little things start adding up, and so we're like, crap, that's more margin squeeze. As my margin gets squeezed, my ability to self-fund growth also gets squeezed.

15:05 Stephen Brown

The third lever is to slow down payments. That to a certain degree is kind of what I was talking about earlier. Can I get better terms and defer how long I'm paying for my inventory, so that I have more time to sell said inventory? So that is the one lever, better terms.

15:30 Stephen Brown

One thought process I came across last year. Oh, sorry, a little clicking problem.

Again, there's another analysis you could consider. If I went back to my supplier and said, hey, I'll pay a little bit higher unit price if you'll give me better terms. Again, you want to do a cost analysis. Would higher unit prices be cheaper than lending?

16:06 Stephen Brown

Now again, I'm talking about self-funded growth here. I'm getting a little ahead of myself into a future webinar where we're going to talk about debt, but that's another strategy you could use to improve things. So in that case, you're actually decreasing your profit margin to speed up your cash.

16:28 Where the math breaks

Stephen Brown

Now, what I've talked about is really a mathematical way of looking at things. Let's talk about some issues where cash should also be considered.

Now, one is obvious. We're here to talk about self-funded growth. If you're like, I want to grow faster than that number, and I can tell you for a lot of people that self-funded growth rate is going to be a lot lower than you probably want it to be, well, then you're going to have to figure out how to get additional cash into your business, either in the form of investment or debt. And investment could be two parts, investment from outside parties, or you, the owner, putting more cash into the business.

17:12 Stephen Brown

This next one's really important. This is where the asterisk comes in. What I've talked about is a mathematical way of looking at self-funded growth. The reality is seasonality can break that number to a certain degree.

Because we're looking at annualized averages, but in reality, let's say you're doing your buildup for holiday season, you will probably need more cash than your profits are creating. So again, when you're doing mathematical equations, that doesn't represent reality.

17:54 Stephen Brown

Now, how much cash do you actually need for that seasonality? Well, to do this right, you would really need to do a cash flow projection. And that will help you tease out the nuances of actual cash demands. Because there can be ebbs and flows where you need more working capital than the math would tell you over an average 12-month period.

18:22 Stephen Brown

Another thing to consider is, hey, I stumble on this incredible opportunity. The biggest thing I see here is wholesale. So you might be cruising along and thinking, hey, I can self-fund growth. And then you get a deal to go into Costco or Target or one of these big retailers. They can be incredibly cash intensive, because in two ways, they can require large inventory orders that you have to fulfill upon, and their payment terms are longer.

19:04 Stephen Brown

So all of these things can break this mathematical limit that I've talked about. What I like to think about with this mathematical limit is, it's a way to frame where to think about things in a quick and dirty way, without going through and doing extensive cash flow forecasting. And it also helps me understand, if I go higher than that number on a growth rate, I'm going to have to find additional capital.

Although, point two, seasonality, probably going to have to find some additional capital regardless. Again, this mathematical equation doesn't take into account seasonality. It doesn't take into account existing cash you may have to be able to use. So there are a lot of nuances when you go through this in detail.

19:49 Stephen Brown

So what are the key takeaways? Well, every business has a self-funded growth limit. And I don't think people typically think about this, but they really should, because it explains why these businesses are such cash monsters.

It's also one of those things, the faster you grow, the more cash you're going to need. And so you can easily get into a debt spiral, and bad debt can make things worse.

20:19 Stephen Brown

So we're going to do a webinar on debt. We're going to do it in June, just because we have some other things we want to cover. But in June we're going to cover debt, and I'm going to talk a little bit about debt spirals. This is a really important principle, because when you exceed your self-funded growth limit, you are going to have to take on debt or investment. And if you're not careful, you can have bad debt, chasing bad debt to keep up with the cost of that capital.

20:50 Stephen Brown

Growth consumes cash before profit arrives. This is logical if you take a step back and think about it, but I've tried to explain in simple terms how that is. Again, your limit is determined by two things, how profitable you are and how cash hungry your model is.

Finally, knowing your number lets you plan and react. And this is one of the biggest things we want for our customers as they get better accounting. We really want them to use their data intelligently.

21:20 Stephen Brown

So again, I have put in the chat, if you look into the chat, there is a link. I'm only going to make this link available to this audience, and I'm only going to keep it up for about 30 minutes after this webinar. If you would like to meet with me and talk through your self-funded growth limits, even if your accounting isn't where it needs to be, we can estimate what that is. I'm happy to do so, no cost, but only for those who are on this webinar live. So go into the link, you can book me, we'll have 30 minutes to talk.

22:03 Stephen Brown

To conclude, we'll take some questions, but I also want to take note of next month's webinar. We are going to talk about a benchmark that we're producing for the first time, where we're going to look at some 2025 trends that we're seeing with our customers, specifically revenue trends, profit trends, cost of goods trends. We're going to be looking at a number of trends. I'm going to be going over that with our Director of Growth, Stacy Walker. And we are going to talk about what we're seeing and what that tells us. So this should be a really interesting webinar.

So what questions do we have as we are coming to the end of this quick 30 minute period?

22:41 Lauren Maillard

Stephen, how do you calculate capital intensity?

22:45 Stephen Brown

The working capital intensity, first you have to have your cash conversion cycle. And then you divide that number by 365.

So really, this is a really painful thing to do by hand. And even, I've got a spreadsheet that I use to calculate it. It's intense. And then you just take that number, you come up with the ratio, take that days number divided by 365, and that represents how much working capital gets tied up in your business.

23:26 Lauren Maillard

Do you have an idea of the growth rate for ecommerce businesses? Like with the clients that you see most of the time?

23:36 Stephen Brown

That's probably a good question for next month's webinar, right?

23:41 Lauren Maillard

But what do you?

23:42 Stephen Brown

I don't know that we're going to get that in this first benchmark.

If you think about it, I would say it's not uncommon to have a cash conversion cycle of 90 to 180 days. If you were to take that number, let's split the difference. I'm just going to do the calculation. We'll do the calculation real time.

So if you have a 150-day cash conversion cycle, 41% of your revenue is going to get tied up in working capital.

24:29 Stephen Brown

And so then if we wanted to say, hey, what is my self-funded growth rate? So we'll just round down and say my working capital intensity is 40%. I see a lot of very low margins, let's say 5% net income. And then divide that by 0.4, 12%.

If I were to move, let's say I have a 10% profit margin and a 0.4 working capital intensity, 25%.

25:12 Stephen Brown

That is, these days I don't see a lot of 10% profit margins. So it's more likely the former, whatever that was, 0.5 divided by 0.4. Sorry, that should have been 0.05, 5% profit margin divided by 0.4 working capital intensity, 1%.

That's a lot lower than most people want to grow. But I think that's probably a typical self-funded growth rate based on what I'm seeing.

Other questions, Lauren?

25:46 Lauren Maillard

How can accounting managers help with this? Because accounting managers, if you've got your year-end financials, they should be able to calculate this.

25:57 Stephen Brown

Yeah, I'm going to be rolling out a tool where they could use this. I'm just finishing it up. So we'll have a tool that if you're working with us you could run through. And I'm looking at turning that tool into a web based form that people could use as well.

26:16 Lauren Maillard

What part of the cash conversion cycle have you been the most successful in improving with Solé Toscana?

26:30 Stephen Brown

We haven't. It's been really hard. Cash conversion cycle is really hard.

So right now, like I told you, we are looking at analyzing the ability to air freight things and see if that's going to be better. Although with the war in Iran, air freight's getting really expensive. So we're looking at some trade-offs, because we do exceed our self-funded growth rate.

27:05 Stephen Brown

What I would do as I'm looking at some of these trade-off examples, if I'm exceeding that rate and I'm having to take debt, I would say what's the cost of debt versus the cost of maybe one of these other strategies. That's how I would look at it.

Because at the end of the day, let's say it's neutral on profit, but it decreases my cash conversion cycle, that also is going to reduce my working capital requirements, which is net positive. So ideally, even if it's neutral in terms of the cost offset, but I have a shorter cash conversion cycle, that's a positive thing. Because the cash conversion cycle, the other end of it, is more money than I put in. So if I can shorten that, it's almost always going to be a positive thing.

27:58 Lauren Maillard

How does your strategy going out for the next three to five years, or even beyond that, determine if you want to self-fund or if you want to take on debt?

28:11 Stephen Brown

I think for most people, what I see is most people want to grow, grow, grow. And I don't think they fully understand the implications of fast growth, which is why I'm really trying to educate on these concepts.

We actually had a podcast that dropped yesterday, the Ecommerce Finance Podcast, which was a really great episode with one of my favorite customers. Not my favorite customer, I love all of my customers, but I love Matthew because he is self-funding growth.

28:43 Stephen Brown

And he talks about how he does that. He's doing that partly because he's very profitable. He's very lean on his inventory. He's willing to stock out. We went through very extensively how he's accomplishing this.

And let me tell you, he has a very successful business and it's growing decently fast. So you can have growth, but you're going to have to have good profit margins. And Matthew is super disciplined. He scrutinizes everything. And I think it's allowed him to self-fund growth.

29:18 Stephen Brown

So if you want a companion conversation on this topic, go to the Ecommerce Finance Podcast and listen to the latest episode where I had a conversation with Matthew from House of Joppa. It's really incredible what he's doing. I don't see this very often. I think he's showing an alternative path to how you can grow your business.

29:40 Stephen Brown

Growth is not always the answer, right? Growth can be stressful. Growth can be risky. And I think for these businesses, the one thing I take away is growth is going to create pressures on cash, and probably stress for you that you might not want to have.

Hope to see you next month. Thank you for joining this month.

30:03 Lauren Maillard

Thanks, Stephen.