How well do I use my capital to generate sales?
How well do I turn my sales back into capital?
There are two fundamental metrics that will help you focus and better understand your ability to grow.
Omnichannel companies are complex systems. There is A LOT going on between your product development, supply chain, logistics, customer support, marketing and finance. Add in multiple channels each with their own nuances and cash cycles and the complexity starts increasing exponentially. And you are operating in wildly fluctuating markets often relying on platforms you don’t control. There are always fires to put out. So it’s easy to get distracted.
Thinking of the company as a machine is a helpful analogy. While there are tons of moving parts and inter-connected systems, the purpose of the machine is to generate returns based on various capital inputs.
The goal of management is to build the most efficient machine possible and make it as big as its market allows.
Our machine’s efficiency can be boiled down to Capital Efficiency and Cashflow Efficiency. Once we understand those, we can better understand Growth.
Capital Efficiency
The best metric to understand Capital Efficiency is Net Sales divided by Net Working Capital.
Let’s do a quick refresh on Net Working Capital. Working Capital is sometimes defined as Current Assets - Current Liabilities. Current just means within a year. Net Working Capital is more commonly defined as excluding cash and cash equivalents from Current Assets and excluding current debt from Current Liabilities. The idea is to focus on operating assets and liabilities and to focus on assets that directly drive revenue. In omni channel, this is a useful distinction.
So the Net Working Capital definition boils down to:
Inventory + Accounts Receivable - Accounts Payable = Net Working Capital
OK, so Net Sales / Net Working Capital is telling us how well can we turn our operational assets into sales. So if it’s 2.0, then we generate $2 of sales for every $1 NWC.
To give you sense of some public companies,
Hermes is at 25 and LVMH is at 6.7.
Birkenstock is at 3, Nike at 9.1 and On is 4.8.
Olaplex is at 4.8 as is ELF.
Lululemon is at 20.
Obviously some segments require more NWC than others, but across all segments, the higher the better.
This ratio also tells us how much NWC we will need to support growth. So if you want to grow 25%, 50% or 100%, you have a quick sense of how much NWC you will need and once you know that, you will have a sense of whether you can support that growth organically or will need outside capital.
Quick aside. What about ROIC?
I love ROIC as a measure for capital efficiency. I believe ROIC is the right measure to understand your capital efficiency over time whereas Net Sales / NWC is the correct measure to understand your capital efficiency right now. Because ROIC includes all your invested capital, it’s hard to make actionable metrics that impact this capital base. Whereas there are multiple way to improve your Net Working Capital. So, ROIC is the acid test scorecard over time, but Net Sales / NWC helps you measure your improvements period to period.
Cashflow Efficiency
The best metric to understand Cashflow Efficiency is Free Cash Flow divided by Net Sales. This tells how how effective we are at turning sales into something we can actually use which is cash.
Quick aside. What about profits or EBITDA?
The quick answer is we don’t buy inventory with profits. We buy it with cash. Just like you don’t pay your employees, your vendors or yourself with profits, you pay with cash. Sure, in a lot of businesses, EBITDA approximates Free Cash Flow. But that sloppiness has ended countless companies who are positive they are profitable, but go out of business because they run out of cash.
So, Free Cash Flow divided by Net Sales tells us how efficiently we are turning sales back into cash or capital.
Let’s look at our public companies again.
Hermes is at 26% and LVMH is 13%.
Birkenstock is -21%, Nike is 0% and On is 11%.
Olaplex is 39% (wow) and ELF is 7%
Lululemon is 17%
Capital → Sales → Capital
Our two metrics describe the cycle. We deploy capital to generate sales and we turn those sales back into capital.
The more effectively we turn sales into cash, the more cash we have to generate sales and the virtuous cycle has begun. Let’s look at a super simple example:
These two metrics also help us understand our ability to fund our own growth without using outside capital. Assuming the current customers keep buying and we can continue finding new customers (two big assumptions), any growth we want beyond our organic rate will require outside capital.
From the table above, you can also see how impactful improvements in our capital efficiency and cashflow efficiency can be. 25% improvements in both yield greater than 56% improvements in FCF. The improvements compound with each cycle.
So this raises an important consideration. Are you better off focusing on making your machine more efficient and thus increase your organic growth rate or are you better off raising outside capital?
In the ZIRP environment, we got this backwards. Capital was easily available and thrown into machines that were wildly inefficient creating vicious negative cycles and a lot of bad processes and habits. The industry is still working through this.
How do you create more capital efficiency and cash flow efficiency? I will lay this out in future posts.
Source for public market data is Elephant Herd Index for April 2024 and is LTM for all numbers.