The 5 Reasons why your Ecommerce Business is a Cash Eating Monster
It’s the end of the month.
You’ve just paid payroll and the monthly rent.
You look at your depleted bank account and realise you don’t have enough cash to pay the deposit for your next order of stock.
It makes no sense. Despite a healthy month of sales, you don’t have any cash in the bank.
Where did it all go?
As chartered accountants and specialises in Ecommerce businesses, we see this problem all the time. It’s the number one question we get from every founder we work with – where is my cash!?
In this guide, we’ll unpack the 5 reasons why your Ecommerce business has a cash flow problem and how you can fix them.
1) You don’t understand your true Gross profit margins
Revenue is a vanity metric.
Many founders intimately understand the sales that are achieved on a weekly or monthly basis. It’s what most people focus on. How many sales I made each day.
The biggest problem with just looking at sales is that it doesn’t tell you if you’re actually making any profit. What’s more important than your sales is your Gross Profit.
Gross profit is more important than measuring sales, because it shows the quality of your sales.
Truly understanding your Gross Profit
Gross Profit is the most important metric in your business because it is a true measure of the profit you business generates to cover your fixed expenses, like wages and rent.
To calculate your Gross Profit, you need to consider all of the direct expenses associated with selling your product. These direct cost expenses, includes:
- Cost of Goods Sold (the cost of your product)
- The inbound shipping costs/freight costs
- Merchant and selling fees (Amazon, Stripe, Paypal and Afterpay fees)
- Fulfilment costs – postage and pick and pack charges
An example of how to accurately calculate your gross profit:
What is a healthy gross profit margin?
Your Gross profit margin will vary depending on what you sell. If you sell commoditized goods or a reseller of other brands, your gross profit margins could be as low as 25%.
If you sell your own products, classic DTC – you should be achieving margins between 40% – to upwards of 60%.
It goes without saying – the higher the gross profit margin, the better. The best businesses in the world have strong Gross Profit margins.
So what’s a good gross profit?
If you’re an FMCG business that does less than $10M of sales every year and your goal is to build a profitable business, our recommendation is that you should target gross profit margins of 40%+
If your margins are lower than that, you need to be selling a lot of product to generate the net profit and cash flow.
Allow me to explain. The diagram below shows a business with $800k of annual fixed expenses. The graph shows how much in sales the business needs just to break-even on these costs at varying gross profit margins.
At a 60% gross profit margin, the business only needs to do $1.3M of annual sales to break-even on $800k of fixed costs.
At the other extreme, the business needs to generate $4M of sales at a 20% gross profit, just to achieve the same result. That is a whole lot more effort for the same financial result.
Gross Profit margins are one of the most important metrics to understand your businesses financial health. As a founder and manager, your goal should be to innovate on your product and service to explore ways to maximise your gross profit margins.
2) You’re excessively discounting just to make sales
I’m guilty of it. You’re guilty of it. We’re all guilty of it.
It’s the default response when we’re trying to attract new customers and grow our top-line sales. To make our product more attractive to the market.
It’s easy to knock-off 10%, 15% or even 20% off the sales price. We can get so obsessed with discounting that it becomes standard practice in our business.
However, rarely do we step back and truly understand the costs of this run-of-the-mill approach to winning new business.
As an accountant and specialist in Ecommerce business models, I will comfortably tell you that discounting is the number 1 killer of profitability.
It’s a default tactic often deployed by amateur marketers to ‘acquire more customers’, or founders who are not confident in their product.
As we outlined above, gross profit margins really matter.
Let’s use this Ecommerce business as an example.
This Ecommerce business does $1M in annual sales. It generates a 10% profit margin on the back of these sales, which is a pretty standard target profit margin. You wouldn’t want to be doing any less than that.
As you can see, willingly offering a 10% discount essentially erodes the company’s profitability.
At a 20% discount, it loses money.
Now there’s a very big assumption that is behind these financials. This example assumes that your sales volumes don’t increase as you lower the price.
I mean, if you discount your product, you should expect unit sales to increase as a result? Right?
Well, yes it should – but by how much?
How many extra unit sales do I need to make to cover the discount?
The common argument with the discount tactic is that a business can make up the loss in margins by increasing sales volume.
So the million-dollar question is- how many extra sales do I need to make for every % discount?
The table below demonstrates the additional unit sales required for every % of discount that you provide you customers.
In this example we assume an Ecommerce business sells 1,000 units of product a month at a 40% gross profit margin.
Now, discounting the product by just 15% means the company needs to increase their sales volume by an additional 60% just to make the same gross profit dollars if they charged full price.
In other words, instead of selling 1,000 units at full price, the business needs to sell 1,600 units just to make the same gross profit dollars at a 15% discount.
And here’s the thing – if the business doesn’t sell that additional 600 units under the discounted rate, the business is worse off from a financial perspective.
So bottom line – if you’re not generating the additional volume in your discount campaign – you are losing money.
3) You’re spending too much on Customer Acquisition Costs
Not generating ROI on marketing and advertising costs is a core reason why your Ecommerce business is not making money.
How to understand the true ROI on your customer acquisition costs
Customer Acquisition Costs (CAC) are all expenses incurred in acquiring/winning new customers.
Typically these include:
- Wages for your sales and marketing team and agency;
- Digital advertising expenses like Facebook ads, Google Adwords etc.
If you are aiming for profitable growth, your total Customer Acquisition Costs should be less than 10% of revenue.
As business owners it’s easy for us to get swept in the vanity metric of ‘revenue growth’. (Trust me; I’ve been there, too.)
We can get obsessive about pumping lots of money into paid advertising and sales teams, which should drive revenue growth.
The problem is this: if the overall costs to acquire these new customers outweigh any future potential profit, you’re essentially losing money with no gain.
You may have other reasons for the outreach, but — from a financial perspective — it’s kind of pointless.
It’s like buying friends to make you happy. Nobody wants that.
4) You’re carrying too much stock
Inventory management is by far the most critical aspect of running a successful Ecommerce business.
Inventory management is a science. It takes data and an acute understanding of the market to get the balancing act of inventory purchases just right. If you carry too much stock, your cash becomes tied up.
These funds could otherwise be used to fund the rest of your business. This cash flow problem can be compounded if your product is perishable or depreciates quickly—as it loses value each day you hold on to it.
In a worst-case scenario, you could be left with no cash and no product.
On the flipside, if you carry too little stock, you might run out and have nothing to sell to your customers. This can cripple your future sales, as your revenue is hamstrung until you can be restocked.
Measuring metrics like stockturn and inventory days is an approach to help you manage this fine balancing act.
You can calculate your inventory days with the following formula:
INVENTORY DAYS = INVENTORY VALUE / MONTHLY COST OF GOODS SOLD x 30
What are Normal Inventory Day Benchmarks?
Average inventory days vary between industries and depends on the product type and business model. For example, companies that sell perishable or fast-moving products, like food, will have a lower inventory days benchmark than businesses selling non-perishable or slower-moving products, like cars.
Below is a guideline of inventory benchmark days for key industries from the 2010 issue of Supply Chain Digest.
Every business is unique, so these inventory days benchmarks should be used only as a guide. For example, in 2017, Apple’s average inventory days was a mere 11.18—an enviable figure, given that the benchmark for consumer tech is 30 days. If your inventory days are higher than the benchmarks, consider ways you can reduce them.
Lower inventory days result in more cash. It’s one more goal as you strive for operational excellence.
Tactics on Reducing Inventory Days
Obsolete and slow-moving stock are the culprits behind bloated inventory balances. These are the products that have become dated because a newer, shinier version has been launched in the market. This is especially real for if you’re a business subject to trends and seasonality, like fashion.
There are a number of methods to identify obsolete stock. You probably already have a feel for what needs to be written-of. For a data-driven approach, generate a stock report from your inventory management system and filter the data to identify the last sale date.
If the time period from your sale date to today’s date is greater than your Inventory Days metric, assess whether it can be sold at a discount price, or at worst case, written off completely.
In order to manage your inventory, we recommend using an inventory management system that integrates to your accounting system. This will take a lot of the guesswork out of inventory control.
Selling obsolete stock may have an impact on short-term profit. But they will be offset by the long-term benefit as your carrying costs are eliminated, and immediate cash flow is realized.
Ignore sunk costs.
5) You’re not regularly looking at your numbers
When it comes to understanding the financial health of their business, most Ecommerce founders look at the following metrics:
- Value of sales made per day (found on Shopify/BigCommerce website)
- Cash in the bank
There are a few flaws with relying on this approach to running your business.
The first is that as we saw earlier – revenue is a vanity metric. The amount of sales you make don’t tell you if you are making a profit on those sales.
Secondly, the cash in your bank account is not your money. That cash could represent funds owed to suppliers, taxes and even money set aside to pay for future stock.
To understand your financial position, you need to be looking at your accounting system. This should be the source of truth to understanding your financial position.
We recommend a cloud-based accounting system like Xero.
When it comes to the financial management of your business, we recommend you this cadence:
- Bookkeeping should be completed on a weekly basis
- Forward cash flow projections should be reviewed and updated on a weekly basis
- Your overall financial performance should be reviewed on a monthly basis
In terms of reviewing monthly KPIs, we recommend the following metrics as a start:
- Sales for the month
- Gross profit
- Net Profit
- Average discounts and returns rate (%)
- Free Cash Flow
- Cash Conversion Cycle
Getting on top of your numbers can be a complex and time-consuming pursuit.
Starting with this basic framework will do 80% of the heavy lifting to help you run a more successful and profitable Ecommerce business.
If you need help implementing this in your business, request a call with us to setup a complimentary financial review of your business.