A New Company
Let’s take, for example, a brand new company that’s getting into the blue widget business. For fun, let’s call the owner Carlos. Widgets cost $50, and retail for $100. For simplicity, we’ll assume that Carlos has to pay in cash up front (which is somewhat common when you just start out), that he orders once per month, and that he receives his inventory immediately (clearly, not very common).
Carlos has saved up and he has $5k to start out with, so he buys 100x widgets. In the spreadsheet, Qty is the quantity that Carlos has in stock, COGS stands for cost of goods sold (Carlos’ cost on the items), and Retail is the retail value of the inventory.
Now, 30 days later Carlos is doing pretty good. He’s sold 75 out of his 100 blue widgets.
Time to reorder! Since demand is increasing, Carlos needs to spend all $7,500 in his bank account to buy 150x blue widgets. Now he has 175 in stock, but no cash.
Things keep going well for Carlos. In fact, he’s decided to expand his business into green widgets. At day 60 he’s down to 50 blue widgets. He orders 150x again, but also buys in to the green widgets with another investment of $5k for 100x.
Wait a second. Things are going pretty good, but Carlos keeps spinning his wheels when it comes to cash flow. When he has a lot of cash on hand, he keeps having to spend it all on inventory to accommodate his growth. When inventory looks good, he doesn’t have any cash. He’s profiting, but there’s no profit to spend on anything other than inventory.
Now multiply this over several product lines, with multiple vendors, all of which have different payment terms (cash, credit cards, Net 30), and all of which have various delivery times, and then factor in shipping damages, warehouse space, shelving units, packing material, employees, marketing, and probably 50 other factors, and you basically have us. It’s easy to see how, despite really fast growth and lots of cash coming in and out, there isn’t a whole lot left, even if you’re showing a large profit.
The situations that really kill us are vendors that we spend a lot of money with but also have slow lead times, forcing us to forecast out further than 30 days. For example, we might place an order in July to cover us through September. We get the products, have 30 days to pay for them, even though we won’t turn the inventory over for several more months. At which time, we’ll be placing an even bigger order with the same company. It’s a vicious cycle.
It’s a problem that we’ll probably never rid ourselves of completely. The interesting thing is that this problem doesn’t stop as you grow. If anything, it might get worse. Take the case of Zappos.
The Super Duper Gigantic Company
In an excerpt from his new book, Delivering Happiness, in last month’s Inc Magazine, Tony Hsieh authored an article titled Why I Sold Zappos. Essentially, to sum it up for you, the reason was because of inventory:
At the time, Zappos relied on a revolving line of credit of $100 million to buy inventory. But our lending agreements required us to hit projected revenue and profitability targets each month. If we missed our numbers even by a small amount, the banks had the right to walk away from the loans, creating a possible cash-flow crisis that might theoretically bankrupt us. In early 2009, there weren’t a lot of banks eager to give out $100 million to a business in our situation.
That wasn’t our only potential cash-flow problem. Our line of credit was “asset backed,” meaning that we could borrow between 50 percent and 60 percent of the value of our inventory. But the value of our inventory wasn’t based on what we’d paid. It was based on the amount of money we could reasonably collect if the company were liquidated. As the economy deteriorated, the appraised value of our inventory began to fall, which meant that even if we hit our numbers, we might eventually find ourselves without enough cash to buy inventory.
These issues had nothing to do with the underlying performance of our business, but they increased tensions on our board of directors.
The fact that Zappos had these issues is both scary and reassuring at the same time.
We discuss this a lot. It’s probably our biggest growing pain, even more so than hiring, scaling our technology, or developing our warehouse operations. Now, most companies aren’t Zappos, they’re more like us. Is there any solution to this problem?
Yes, there is, and we personally know several e-commerce companies that no longer have this problem. Their solution: they have a shit load of cash. They don’t rely on bank lines to buy inventory. Somewhat of a necessity in the beginning, you can see from Zappos how bank lines can sour quickly based upon factors outside of your control. We’ve also experienced a TON of red tape trying to get new lines or increase existing ones. When the application process involves 10 meetings, personal credit checks, personal tax returns, the SBA’s backing, and a 100 page business plan, you have to question whether it’s worthwhile. Unfortunately for Zappos, they’re too big to solve the problem with cash. They’ve outgrown any potential “sweet spot.”
There are really only two ways for a retail business to get a shit load of cash. 1) You start out with it because you’re rich. 2) You slowly but surely build it up over years and years of profits.
Since #1 doesn’t apply to us, #2 is what we’re shooting for. #2 is how we’ve seen other successful e-commerce companies do it. This isn’t a one or two year thing, it’s a 5-15 year thing. It means absolutely minimizing other expenses (most notably, new product lines, employees and warehouse costs) until that revolving cash flow cycle eventually starts to turn in your favor. If you’re profiting, it will (and if you’re not, well, you’ll be out of business). We see it slowly getting better. The difficult part is controlling expansion – expand too slow and you lose market share, expand too fast and you hit the reset button and start that bad cash flow cycle all over again.
It’s a fascinating topic, one that I think is often taken for granted when starting a retail venture. At first glance, you just wrongly assume that if you’re profiting you’ll have no cash flow problems, which definitely isn’t the case.
Side note: as I’m about to hit “post” I realize that this is my 400th post since switching to WordPress and moving this blog from SportsLizard, where I had another 296. It kind of blows my mind to think that I’ve written almost 700 posts over the last five years. If anything, I suppose it shows I’m consistent when I apply myself to something. Thank you to everyone who has ever read, commented, or emailed!