If you are an e-commerce business, it is important for you to undertake working capital management as it:
- Helps your business in optimizing inventory
- Ensures continuous supply
- Helps in releasing funds for other important aspects of the business
Having an optimized level of inventory is a key driver for an e-commerce business to improve year on year.
One of the most challenging trends that online businesses face is the rapidly changing customer behavior. Customers are demanding a wide range of products and expect such products to be delivered in very short timeframes. Further, they even want the delivery to be fast with efficient return options.
Also, due to increased and uncertain demand from customers, the e-commerce stores have extended days in receivables. Plus, the seasonality and stock availability issues increase the Net Working Capital challenges for e-commerce businesses.
As a result, online players are currently adjusting their business models in the face of such changes. The movement of cash investments is an important aspect for an e-commerce business to function successfully.
Accordingly, e-commerce businesses must continue to optimize their operational processes to minimize their working capital position. The cash released as a result of such improved working capital position will help a business to use it for transformation.
In this article, we are going to discuss what is working capital, why, and how e-commerce businesses need to optimize their working capital position.
What is Working Capital?
Working capital is the cash tied up in the everyday running of a business. For example, payment to creditors, salary paid to workers in the warehouse, purchase of inventory, etc., Such an investment can be easily converted into cash. As a result, working capital is also called short-term capital.
Further, the attributes of working capital are such that it does not earn any interest. For instance, capital invested in inventory would not generate any interest for a business.
Therefore, it is important for e-commerce businesses to manage their working capital levels well. An optimized level of working capital will ensure that the business has sufficient cash to meet day-to-day operations and profit to counter the cost of capital.
In accounting terms, Working Capital refers to the difference between the current assets and current liabilities of a business. That is, it refers to that part of a firm’s capital that is required for financing its current assets. In other words, working capital refers to the fund amount necessary to cover the cost of operating the enterprise.
Where current assets are the assets that are expected to be sold within the normal operating cycle of a business. It may include short-term assets such as cash, marketable securities, debtors, and inventories.
While current liabilities are the short-term obligations of a business. That is, such liabilities are expected to be settled within the normal operating cycle of a business. It may include short-term liabilities such as trade payables and outstanding payments.
For instance, the working capital of Amazon Inc for 2020 comprised accounts receivable, inventory, and accounts payable. Further, variables including seasonality, inventory management, category expansion, the timing of cash receipts and payments, vendor payment terms, and fluctuations in foreign exchange rates impacted the working capital at a given point in time.
Importance of Working Capital For an E-Commerce Business
Just like any other business, working capital is the lifeblood of an e-commerce business. It must develop effective working capital policies to ensure growth, profitability, and sustainability. A lack in the management of working capital may lead to a total collapse for the business.
The following are the reasons why working capital is important for e-commerce businesses.
An efficient amount of working capital ensures that an e-commerce business has an uninterrupted flow of cash.
Cash is needed to stock and track inventory, support customer service, run digital marketing campaigns, and pay employees for fulfilling customer orders. It is also required to meet the inventory challenges that arise on account of the seasonality of products and uncertain demand.
Thus, financing from trade creditors or suppliers ensures that an e-commerce business has the cash to run day-to-day operations. It is not tied up in surplus inventory and can be utilized for other aspects of the business.
2. Continuous Supply
For an e-commerce business, sufficient availability of working capital means it has sufficient cash to meet unforeseen demand. There are certain products that have seasonal demand.
Moreover, customers demand a variety of products on e-commerce platforms. Thus, there is a lot of uncertainty involved with regard to demand for products.
If an e-commerce business has access to sufficient working capital, it will be able to meet such unforeseen demand easily. It will not have to face inventory shortages or situations like backorders or stockouts. In other words, the e-commerce store will have a continuous supply of goods.
3. Enhanced Goodwill
A business having sufficient working capital will be in a better state to serve customers with a wide variety of goods and services. This is because it has the ability to invest in infrastructure. Such an investment may include spending on inventory management software, data servers, and networking equipment.
In addition to this, an e-commerce business may also spend on technology and content to improvise on research and development of new and existing products and services. Such expenditure may result in the development, design, and maintenance of stores, curation, and display of products and services made available in its online stores.
Besides investing in technology and content, an e-commerce business may incur costs in operating and staffing fulfillment centers, physical stores, and customer service centers.
All such investments help an e-commerce business in implementing improvements in their operations and enhancements to their customer self-service features. Enhanced customer service means increased goodwill for the business.
4. Improved Credit Profile
A business having sufficient working capital at its disposal is in a better state to meet its short-term obligations. For instance, operating leases, interest on short-term loans, accounts payable, product returns, customer liabilities, current debt, acquired digital media content, and other operating expenses.
An e-commerce business that makes timely payment of its financial obligations has improved credibility. As a result, such a business is able to get additional funds easily as it has a good credit-paying history.
For instance, e-commerce businesses having a good credit-paying history are in a better state to negotiate the payment terms with vendors. Favorable payment terms have a positive impact on the working capital cycle of the business. That is, it is able to extend its Days Payable Outstanding (DPO). This enables a business to utilize the trade credit towards other aspects of the business.
Likewise, an e-commerce business can easily take short-term loans from banks and other financial institutions. Or else, they can obtain funds from alternative sources of financing such as revolving lines of credit, asset-based financing, business credit cards, and small business administration loans.
Such additional funds help e-commerce businesses to invest in equipment acquisition, debt refinancing, and business expansion. The only thing that an e-commerce business needs to ensure before applying for financing is that it should have enough liquidity and a stable cash flow.
5. Enhanced Return On Investment
Investors want a consistent return on their investments. Adequacy of working capital enables an organization to pay quick and usual dividends to its investors. This gains the assurance of its investors and creates a positive market to raise additional funds in the prospect.
How is eCommerce Working Capital Calculated?
There are two possible ways to calculate working capital. One is through the balance sheet and the other is through the operating cycle.
1. Balance Sheet Concept
Under the balance sheet concept, there are two concepts of working capital. These include Gross Working Capital and Net Working Capital.
a. Gross Working Capital
The Gross Working Capital refers to an e-commerce firm’s investment in Current Assets. As mentioned earlier, current assets are the assets, which can be transformed into cash within a financial year or operating cycle. For an e-commerce business, the current assets may include cash, short-term securities, debtors, bills receivables, and inventory.
An e-commerce business’ investment in current assets must be just sufficient. That is, the investment in current assets should neither be in surplus nor deficit. This is because excess investment increases liquidity but reduces profitability as idle investment earns nothing. Whereas, an insufficient amount of working capital can threaten the solvency of the firm. That’s because such a firm does not have the ability to meet its obligation.
Note that the Working Capital needs of an e-commerce business may fluctuate depending upon the changing business actions. As a result, it may cause excess or shortage of Working Capital regularly. Thus, working capital management can control the imbalances
Since Gross Working Capital is the amount available to finance current operations, this aspect requires an e-commerce business to arrange funds to finance current assets.
The Gross Working Capital formula is as follows:
Gross Working Capital = Current Assets
Let’s consider the example of Amazon Inc to understand how to calculate working capital for an e-commerce business. For the year ending December 2019, the following are the current asset balances of the firm:
|Cash and cash equivalents
|Accounts receivable, net and other
|Total Current Assets
Thus, Gross Working Capital of Amazon Inc for 2019 is:
Gross Working Capital = Total Current Assets = $ 96,334
b. Net Working Capital
Net Working Capital refers to the difference between the Current assets and Current Liabilities of an e-commerce business. Current liabilities are the outsider claims which are expected to arise for payment within a bookkeeping year. The current liabilities of an e-commerce business may include creditors or accounts payables, advanced revenue, and outstanding expenses.
It is important to note that the Net Working Capital of an e-commerce business can be positive or negative. A positive net working capital will occur when current assets go beyond current liabilities. Whereas, a negative working capital occurs when the current liabilities are in excess of the current assets.
Networking capital is a qualitative concept relative to gross working capital. It indicates the liquidity position of a business. Further, it suggests the extent to which working capital needs may be financed by enduring sources of funds.
Also, the networking capital concept demonstrates the availability of long-term and short-term funds for financing current assets. Note that for every business entity, a particular quantity of net Working Capital is permanent. Therefore, long-term funds are used to finance such a portion of working capital.
The above explanation demonstrates that both the Gross Working Capital and the Net Working Capital are important to manage an e-commerce business efficiently. There are no defined rules to determine an e-commerce business’ Gross and Net Working Capital. However, these amounts depend on the business activity of the firm. Every e-commerce business concern should have neither redundant nor cause excess Working Capital. Nor it should be short of Working Capital. That’s because both the conditions are harmful and unprofitable for any e-commerce business.
The Net Working Capital formula is:
Net Working Capital = Current Assets – Current Liabilities
Let’s consider the example of Amazon Inc. For the year ending December 2019, the following are the current asset balances of the firm:
|Accrued expenses and other
|Total Current Liabilities
Net Working Capital = Current Assets – Current Liabilities = $ 96,334 – $ 87,812 = $ 8,522
2. Operating Cycle Concept
The operating cycle of an e-commerce business typically consists of four primary actions. These include purchasing inventory from third-party suppliers, selling the product to consumers, collecting cash from customers, and making payments to the third-party sellers.
These activities create fund flows that are unsynchronized. That’s because cash proceeds are typically received before disbursing cash to third-party suppliers. For instance, Amazon Inc has high inventory velocity. That is the firm typically collects from consumers before its payments to suppliers come due. Further, Amazon Inc invests in accounts receivable to extend credit to its consumers. Also, the corporation invests in inventories to fill customer orders punctually.
In other words, an e-commerce business like every other business does not have an instantaneous operating cycle. That is, conversion of cash to debtors and back to cash is not quick. Hence, it needs adequate working capital to finance its operations for such a lag between debtors to cash.
The continuing flow from cash to suppliers, to inventory, to accounts receivable, and back into cash is called the working capital cycle or operating cycle. In other words, the term operating cycle refers to the length of time which begins with the acquisition of raw materials of a firm and ends with the final realization of cash from debtors.
Now, the amount of working capital that an e-commerce business needs depends upon the length of the working capital cycle. The longer the working cycle, the higher is the need for working capital to be maintained.
This is because the funds will then remain tied up in different current assets for a longer period. An e-commerce enterprise with a dropshipping model may have a shorter operating cycle conversion of cash into debtors and debtors into cash is quick.
Thus, the operating cycle formula for a typical business firm is:
Operating Cycle = Inventory conversion period + Receivables conversion period
Let’s understand how to calculate the working capital for an e-commerce business using the operating cycle approach.
How To Calculate Working Capital Using Operating Cycle Approach?
As mentioned above, the amount of working capital needed depends on the length of the working capital cycle. And the working capital cycle of a business is the sum of the inventory conversion period and receivables conversion period.
|Operating Cycle = Inventory Conversion Period + Receivables Conversion Period
Further, the inventory conversion period is the time it takes for an e-commerce business to source the product from the third-party seller and sells the same to the consumer. Accordingly, the formula for the inventory conversion period is:
|Inventory Conversion Period = Average Inventory Cost of Sales/365
Likewise, the account payables deferral period is the length of time that an e-commerce business is able to defer payment on its various resource purchases. Accordingly, the payables deferral period formula is:
|Payables Deferral Period = Accounts payable + Salaries, benefits, and payroll taxes payable (Cost of sales + Selling, general and administrative expense)/365
Finally, the cash conversion cycle of an e-commerce business represents the net time interval between the collection of cash receipts from product sales and the cash payments to the third-party sellers. It is calculated as follows:
|Cash Conversion Cycle = Operating cycle – Payable Deferral Period
Let’s understand this with the help of an example.
Working Capital Example Using Operating Cycle
Say for instance that Amazon Inc has the following particulars with regards to inventory and collections days.
- Average Collection Period from Debtors = 30 Days
- Average Payment Period = 45 days
- Cost of Sales = $ 165,536
- Opening Inventory = $ 17,174
- Closing Inventory = $ 20,497
- Accounts payable = $ 47,183
- Fulfillment = $ 40,232
- Technology and content = $ 35,931
- Marketing = $ 18,878
- General and administrative = $ 5,203
- Other operating expense = $ 201
Operating Cycle = Inventory conversion period + Receivables conversion period
Inventory Conversion Period = Average Inventory Cost of Sales/365
Average Inventory = (Opening Inventory + Closing Inventory)/2 = ($ 17,174 + $ 20,497)/2 = $ 18,835.5
Inventory Conversion Period = $ 18,835.5/($ 165,536/365) = $ 18,835.5/453.523 = 41.5 Days
Operating Cycle = 41.5 Days + 30 Days = 71. 5 Days
Payables Deferral Period = Accounts payable + Salaries, benefits, and Payroll taxes payable (Cost of sales + Selling, general andAdministrative expense)/365
Payables Deferral Period = 45 days
Cash Conversion Cycle = Operating cycle – Payable Deferral Period = 71. 5 Days – 45 days = 26.5 Days
Thus, Amazon Inc takes 26.5 days to change cash into inventory, inventory into receivables, and receivables into cash.
Top Working capital Management Strategies For an E-Commerce Business
e-commerce stores are subject to many risks. For instance, the ability to retain and expand our network of sellers, changes in usage or adoption rates of the Internet, the introduction of competitive online stores, costs of expansion and upgrades of systems and infrastructure, etc.
As a result, an e-commerce business is in dire need of funds to meet these unforeseen circumstances. Though, it has access to an alternative source of funds. But, it must know how to manage its working capital to maximize cash flows and ensure business sustainability.
The following are the working capital strategies that an e-commerce business may adopt:
1. Optimize Inventory Turnover
As mentioned earlier, inventory turnover refers to the number of days it takes for a business to convert its inventory into cash. Thus, an e-commerce business must make the best efforts to optimize its inventory turnover or enhance the liquidity of its inventory. An inventory that can be converted into cash easily releases cash for an e-commerce business to utilize for other important aspects. However, inventory that stays too long in the warehouse may tie up funds that could otherwise have been utilized for other important decisions.
There are various strategies that can help e-commerce businesses to shorten their inventory turnover. One way to do this is to increase the advertising budget of the e-commerce store. Rigorous marketing campaigns can help an e-commerce store to enhance its sale. This would also mean that the inventory gets converted into cash more frequently. But all this is possible only if an e-commerce business is able to implement the marketing campaigns properly.
Another strategy to reduce inventory turnover for an e-commerce business is to make use of cloud-based inventory management systems. These systems have in-built features that help an e-commerce store to monitor inventory and its turnover rates. Such a systemized way of tracking and monitoring inventory helps an e-commerce store to plan future purchases.
2. Negotiation With Suppliers
An e-commerce store may encounter cash shortages due to unfavorable supplier terms. For instance, an e-commerce store may enter into a 30-day agreement with regard to making payments against invoices with a supplier. But in reality, the e-commerce store takes more than 30 days to sell the inventory and generate cash. That’s because the customers at the e-commerce store might request refunds on returning the goods. This takes away funds from the e-commerce store’s revenues and hence affects the available working capital.
Now, a payment term of 30 days in such a situation does not cover those extra days. That is, the days that consumers take in returning the goods and impacting e-commerce store’s revenues as well as working capital. As a result, such businesses are better off negotiating at least 45-day terms with the suppliers.
The point is that a business running an e-commerce store must take into consideration the number of days it takes to sell inventory. It must also consider the costs associated with holding such inventory. After considering these facts, an e-commerce business should then set the payment terms with their suppliers.
3. Obtain Financing
At times, it is difficult for an e-commerce business to obtain loans from traditional sources of funds like banks and other financial institutions. It’s never a good idea for a small business like an e-commerce shop to pull out cash and make lump-sum payments. Doing so will leave a huge gap in the business’ cash flow. On the other hand, financing stabilizes the cash flow by providing funds that the business has to repay across several months. It preserves as much of the available working capital while also boosting it.
As mentioned earlier, e-commerce businesses may find it difficult to apply for traditional bank loans but there are alternative financing options for e-commerce businesses now available. Payment can be handled using digital vs. traditional banks and we can expect this trend to continue These include:
- Merchant cash advances
- Revolving line of credit
- Business credit cards
- Small Business Administration loans
- Asset-based financing
Alternative loans help provide funds for equipment acquisition, debt refinancing, and business expansion, among others. Entrepreneurs only need to make sure that the business has enough liquidity and a stable cash flow before applying for financing. They also need to measure KPIs and make sales forecasts that determine what kind of financing they will need.