Cash flow is the lifeblood of DTC brands, but a slow cash conversion cycle compromises their health. Selling on backorder can remedy this.
This year, the DTC market is expected to grow 15% year-over-year, reaching sales of nearly $20 billion worldwide. The trend is predicted to be ongoing, with growth continuing into 2022 and beyond.
While this is great news to retail brands, it’s also something to be apprehensive about, considering the difficulty in meeting growing demand due to disrupted supply chains.
As these operational and logistical challenges continue to interfere with business development, cash flow will be one of the most important areas to focus on.
As DTC brands grow to meet their growing customer demand, there is a way to better manage cash flow so as to avoid tying up working capital in the ordering and fulfillment of their inventory.
Most DTC brands measure their “cash conversion cycle”—or the number of days it takes to turn investments in inventory into cash flow from sales. The shorter the cash conversion cycle, the faster each dollar of working capital tied up in ordering and fulfillment is converted into cash.
Below, we’ll walk through various examples of how retail brands typically do business and ways to tweak it to improve their cash flow situation—and ultimately flip the cash conversion cycle completely.
What is the cash conversion cycle (CCC)?
The cash conversion cycle is the length of time it takes for a business to convert its investment into profit. Also called a net operating cycle, CCC represents an important metric for measuring the operational efficiency of your inventory.
A steady or negative cash conversion cycle indicates that the business has a high inventory turnover rate and sells inventory before paying for SKUs. On the other hand, a positive cash conversion cycle means that the business’s working capital is tied up until you pay for the accounts receivable.
DTC brand’s typical cash conversion cycle example
The way a DTC brand typically does business is to:
- Order stock.
- Pay for it.
- Once the stock is received, it can be sold to customers.
In that standard operating procedure, a business has to put down a considerable amount of working capital for a considerable amount of time before it’s recovered through sales.
Let’s walk through an example of a sales process from start to finish.
When a business runs out of stock of an SKU, they place a new purchase order with their supplier. Usually, they will place a partial deposit at this point, paying for part of the order.
After that, there is order lead time—let’s say 90 days—where the business waits for the stock to be shipped and received in the business’s warehouse. When the shipment is sent, the business typically pays for the rest of the order.
Due to both of those payments, the business is out of cash.
In some cases, businesses set up terms with their suppliers to shift these payments later in the process. If they have net 30 terms, then the payment will be delayed by 30 days, and so on. Usually, though, if you are ordering your stock from abroad, the manufacturer requests payment in full before they ship the order.
During that 90-day lead time, the business cannot make any sales for that SKU. But, once the stock is received in the business’s warehouse, the business can begin selling the SKU to customers. The business can sell that SKU until they run out of stock again.
Essentially, the cash exclusively flows out of the business until they receive the product. Once the stock is received, the business can begin to receive cash into the business through sales.
Using this method, it takes a significant amount of time to become cash flow positive.
In terms of the cash conversion cycle, businesses may be measuring this in two ways:
- the time it takes to receive the first sale, or the first inflow of revenue when the product is finally received and then sold, or
- the time it takes for their net sales to cover their cost of goods sold (COGS) and become cash flow positive. (Assuming a 50% gross margin, that would mean selling half of an incoming stock consignment to be cash flow positive on that consignment.)
In either case, there is a significant delay and a considerable amount of cash the business puts down out of pocket.
If we assume this business has 90 days of stock on hand and a gross profit of 50%, it would have 45 days of stock left to sell. At that stage, the business is cash neutral for the directly attributable costs on this order.
In this case, the cash conversion cycle is long.
Not only is this hard on a business’s cash flow, but it also creates stress for the team that is on top of the inventory levels and sales. Staying cash flow positive on each SKU becomes a never-ending cycle of ordering new stock.
Let’s take a look at how this changes if, instead, that business optimizes its inventory management strategy by changing the way they handle inventory backlog and sell its products on backorder. (Or check out our guide on lead time reduction and see if shortening the waiting period does the trick.)
What happens when a brand sells on backorder?
Now, we’re going to reimagine the entire process by changing a few key elements…
In this new scenario, the ordering and fulfillment process stays the same.
When the business goes out of stock, they place an order from their supplier, placing a partial deposit for the order. The rest of the payment happens as the stock ships from the supplier. The lead time of 90 days remains the same, so the business has a significant amount of time before they receive the stock and can start fulfilling orders.
Within the new scenario, what changes is the sales.
Instead of having to wait for the stock to be received in the warehouse to make the first sale, the brand decides to start selling immediately—before the stock is shipped or received.
While payments are going out to the supplier for the new stock order, sales are coming in from customers for those products that have not yet been fulfilled.
In addition, there is an assumption that, once stock is received in the warehouse, sales will increase even more, increasing the cadence at which cash flows into the business.
The amount of time the business is out of cash is much reduced, compared to the typical sales cycle, where products are not sold until they are received.
The cash conversion cycle is minimized by selling on backorder.
What this means for the business is that the capital needed to invest in that inventory is reduced. In addition, the amount of time the business is cash flow negative shrinks, as well.
Flipping the cash conversion cycle in this way alleviates stress on the business’s bank accounts and its internal teams, as well.
Let’s walk through one last scenario some businesses use to nearly eliminate working capital invested in inventory.
In this scenario, the business has the same ordering and fulfillment plan we described above with a 90-day lead time, and they are accepting backorders from their customers—but what’s changed is they have changed the payment terms with their supplier.
Instead of paying for their order partially upfront and the rest as it ships, the business has negotiated to pay the initial portion of their order 30 days later (net 30) and the rest 60 days later (net 60).
As these payments shift on the timeline, the cash flows into the business before it ever flows out. And as the product is received in the business’s warehouses, sales are expected to increase at a faster rate, cementing the business’s standing as cash flow positive.
When DTC brands combine payment terms with selling on backorder, they can accept cash for every purchase in advance. Essentially, they are never cash flow negative – what they aim for is a negative CCC. If they ever do have to put money down out of pocket, it would only be a small amount which would be recuperated very quickly.
Regardless of the payment terms, DTC brands can flip the cash conversion cycle and help fund their inventory by selling their products on backorder.
How much funding does the business need?
In the first, more typical scenario, the funding needed to stay cash flow positive is greatest. By selling on backorder, the funding needed is reduced. And in the last scenario, nearly no funding is required to stay cash flow positive.
By flipping the cash conversion cycle through supplier payment terms and selling to customers on backorder, the working capital needed to fund business projects shrinks significantly.
With all the working capital that is freed up, the business could choose to use that to reinvest in growth.
Traditionally, businesses use their own working capital to fund inventory. In this new way of working, the operations are funded purely through sales.
Real life rarely works out perfectly, though, does it?
It’s highly unlikely that businesses will not need to invest a single dollar in their inventory. Conversion rates and customer demand naturally ebb and flow, affecting cash flow.
While things may not work exactly as is described in the examples above, it’s important to point out that conceptually there's a flip in the cash conversion cycle.
When a business improves its numbers by a few percentage points, it translates to significant improvements elsewhere in the business.
Considering the time value of money and the compounding effect of that means that with every small improvement a business makes in their business, they are working their way toward exponential growth.
Do this often, and the growth is potentially limitless.
Is your business ready to flip the cash conversion cycle?
As DTC brands strain to meet growing customer demand in the coming years, managing their cash flow will be more important than ever.
To flip the cash conversion cycle for your business, remember:
- Selling on backorder allows customers to purchase items they want before you’ve received them—perhaps even ordered them.
- Negotiating payment terms with suppliers allows you to receive payment for every order you place—in advance.
- Reducing and flipping the cash conversion cycle reduces stress on your business’s bank accounts and teams, as well.
Cash conversion cycle FAQs
What is the cash conversion cycle formula?
Use the following formula to perform the cash conversion cycle calculation:
Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) - Days Payable Outstanding (DPO)
What is the difference between an operating cycle vs. a cash conversion cycle?
The operating cycle represents the average number of days it passes between a business buying inventory, selling it, and receiving cash for the item. The cash conversion cycle measures how much it takes a business to convert its resources to cash.
What is a good cash conversion cycle?
A good cash conversion cycle is short. In other words, the less time it takes for a business to convert its investment into cash, the better.
How to reduce the cash conversion cycle?
Improving the cash conversion cycle ratio means optimizing business operations to shorten the CCC process. Some of the best strategies include:
- Selling items on backorder
- Allowing upfront payments or deposits
- Speeding up delivery time
- Simplifying invoices and payment process
- Perfecting demand forecasting to improve inventory management