Margins or capital cycles.
That’s it. Everything else is tactics. Everything else, including customer acquisition, serves one or both of those masters. You can simplify how you think of your brand and make better decisions faster if you distill all actions down to how they affect your margins and capital cycles.
Hermes & Costco
Hermes generates an astounding 42% EBITDA margin. Costco, famous for seeking around 10% gross margins, delivers a 5% EBITDA margin.
But Costco cycles capital like no one else. They achieve close to 12 inventory turns per year carrying 30 days of inventory, have a 2 day Cash Conversion Cycle and negative Net Working Capital which is -5% of Revenue.
Hermes carries 223 days of inventory, turns 1.6X per year and has a 180 day Cash Conversion Cycle. Net Working Capital is 4% of Revenue.
Hermes has to invest a lot of capital into inventory, but when they sell it, they reap excellent margins. Costco is the opposite. They tie up little capital in inventory and use their low margins to achieve rapid cycles which quickly add up to huge numbers.
Have to do both
For almost all brands, it’s not a choice between being Hermes or Costco, choosing margins or capital cycles. Most brands have to do both. As our capital cycles extend, we must have the margin to make the wait worth it. Conversely, as our capital cycles contract, we can take lower margin.
Brand leaders tend to focus 10X their attention and efforts on margins as opposed to cycles. So I am not going to rehash margin tactics here.
Quick review of Cash Conversion Cycle
CCC = Days Inventory Outstanding + Days Sales Outstanding - Days Payables Outstanding
To reduce CCC (and increase our cycle rates) we can reduce DIO, reduce DSO or increase DPO.
Everyone is familiar with getting extended payment terms from suppliers and pushing out AP. This increases DPO thus shortening CCC. Using certain credit products in very specific ways can help. For example a Parker no fee 45 day card allows you to pay off the supplier at their max payment terms and then extend your repayment to Parker for that bill another 45 days. Or imagine saving up all your bills to the very first day of your credit card statement and then paying them all on that day and not using the card again until you pay it off and repeat the cycle. And some short term lending with fees like Settle can be worth it as long as you do the math right and avoid negative debt spirals caused by paying back the borrowed capital plus its fee in timeframes shorter than your cycles. So assuming we have exhausted DPO hacks, how else can we shorten our cycles?
For DTC brands, DSO is negligible. And hard if not impossible to shorten. Unless you have a way to get Shopify to pay you on the same day as the sale, DSO hacks are hard.
What drives Days Inventory Outstanding?
I think the simplest way to think about DIO is average inventory over a certain period / average COGS per day over the same period.
We can accelerate sales which will increase daily COGS. Or we can reduce average inventory. Because average inventory is inventory sitting in our warehouse plus WIP we can focus on reducing both.
Trade margin for DIO by making your suppliers your partners
@Mehtab and others have pointed out that foreign suppliers, particularly Chinese suppliers, have better access to lower cost capital than you do. The first ask is for extended payment terms (i.e. increasing DPO). The next ask is for suppliers to use their cheaper financing to hold the raw materials and finished goods longer and extend their terms (i.e. arbing cost of capital to increase DPO). Implicit in this ask is trading margin for cycles. Your supplier is going to need some strong incentive to increase their costs by increasing their borrowings, so what’s in it for them is some combination of increased prices, order volume and order certainty.
The third ask should be to go all the way. To pay the supplier once you have sold the goods thus eliminating DIO for that supplier all together. Why would they do this? Because they can make more money. It’s a long shot, but I would certainly try. Tariff chaos means all the accepted norms have been thrown out the window. So it’s a perfect time to broach new ideas with your suppliers. And if you can pull it off, let me know! I have been plugging this strategy with clients for months, so I would love to hear about someone pulling it off.
Let’s assume we have optimized the hell out of the PO/supplier side of Days Inventory Outstanding. That leaves us with attacking the amount of inventory sitting in our warehouses.
Your customers are your hidden cycle accelerators
The ultimate would be to sell all your inventory before you had to buy it. If we can’t get our suppliers to enable this, can we get our customers to enable it? Some brands do a terrific job of creating pre-buys. But few of us can introduce those mechanics to our model.
Drops can accelerate sales to a single day or a few days. But again, the drop model is open to a few brands and brings other complications.
Inventory comes in waves. As you place orders for all your SKU’s waves of containers hit your 3PL’s. Hopefully much of these new waves are quickly turned into sales. But usually each wave leaves behind some remnants that are stored on the shelves. These remnants add up and quickly balloon our average inventory and our DIO climbs.
The better we can match our inventory buys to our customers’ purchasing patterns, the faster we sell through our inventory. We don’t have inventory languishing on shelves waiting to be purchased. The less inventory in the warehouse, the lower our DIO. Conversely, the more we miss in quantity, pricing and desirability, the more capital we tie up in slow or dead inventory.
Brands with strong repeat purchasing have huge advantages because they can adjust their purchasing better to their sales thereby cycling their capital more efficiently than their cousins who have to rely more on acquiring new first time customers.
There are obviously other factors such as MOQ’s and seasonality which complicate this. But the principal stands. The better we can forecast our repeat customer demand, the less inventory we have to keep on hand.
If you want to increase your capital cycles and reduce the sales side of the CCC, improve your ordering process to focus on the speed of sales. And I think the best metric for this is the IRR. In other words, force your buying decisions to include an IRR and then weigh your inventory capital bets using IRR. I am going to write a post later this week on how to do this.
Conclusion
Brand finance can be complex. So I find it super helpful to distill everything down to margins and capital cycles. How will this action or project impact my margins and my capital cycles? Does this action support both or am I making a trade between margins and capital cycles?
We tend to think in terms of margins because it’s easier. We can do the math in our heads. So it’s critical to emphasize the capital cycles to our teams. Margins and capital cycles. Once we get our teams thinking of both, better decisions and better improvements will follow.
A good, but often hidden example of the value of thinking of both is aligning our inventory buying with our repeat customer demand.