In the late 1990s, spurred on by the potential of the Internet, hundreds of tiny companies sprung into being, determined to disrupt industries and find profit in doing so. A decade later, almost all of them were gone. Many of the famous failures – Pets.com (pet supplies), Boo.com (fashion), and Beenz (digital currency) – now seem to be just a bit ahead of their time, as many of their products have become successes in the modern world.
Which makes their peer that became an incredible success – Amazon – such an interesting story. What was it about books that was different from pets and fashion? It turns out, the difference wasn’t their product - it was their accounting. Specifically, it was the way in which they used something called the Cash Conversion Cycle.
The Cash Conversion Cycle is simply a measure of how quickly you get paid for a product you sell. Imagine your company makes car stereos for Ford automobiles. You buy your parts – transistors, speakers, and more – from your supplier, you process those parts into a radio, spend some time selling it to Ford, and then Ford pays you for the radio.
We can track how long each of these steps take. The time it takes you to make and sell the radio is your Days Inventory, calculated as 365/(Cost of Goods Sold/Inventory). The amount of time between the sale to Ford and you receiving payment from them is your Days Receivable (Revenue/Accounts Receivable). And, finally, it’s important to remember that you too can put off paying your suppliers by placing that bill in Accounts Payable. This period of time is your Days Payable (Cost of Goods Sold/Accounts Payable).
From this, we can determine your Cash Conversion Cycle:
Days Inventory + Days Receivable – Days Payable
This is the “gap” between the time you pay for your supplies and receive payment for your product. You’ll need to finance this gap, either from your own cash reserves or by taking a loan from the bank. This can be costly, and it can reduce your flexibility to pursue other goals, but it’s a vital part of your business.
Now: what if, instead of being a cost, your Cash Conversion Cycle was a source of cash?
This brings us back to Amazon. Amazon sells its products largely to the retail market, or consumers. Those consumers paid with debit or credit cards, and those companies paid Amazon more-or-less immediately. That kept their Days Receivable extremely low – near zero. By managing their inventory well, Amazon kept their Days Inventory low as well, only a few days. Beyond that, like most businesses, they received credit from their suppliers (we’ll say 30 days for our math purposes).
That means that Amazon had a negative cash conversion cycle – minimal days inventory, plus near-zero days receivable, minus 30 days of Days Payable – meant that Amazon received payment for the things they sold before they had to pay for them!
Amazon was able to use this infusion of cash to grow their business. As their business became bigger, the cash flows from their negative cash conversion cycle became larger. Size and influence allowed them to press their suppliers for better terms, giving them more days to pay, increasing this effect. The positive benefits of a negative cash conversion cycle only increased those positive benefits – an exponential cycle.
The Cash Conversion Cycle is an often-overlooked way to analyze the cash flows of a business, but – as you can see from the Amazon example – it can be incredibly powerful. Not only did Amazon escape the dot-com crash, its wild success propelled it to become one of the largest companies in the world today.