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Cash is king, but cash flow and profits can often diverge. That’s especially true in e-commerce, marketplace, and subscription businesses. Understanding how to generate more cash flow from the same profit pool can help your company scale faster. In fact, it’s one of the secrets to Amazon’s success since early days.
A Harvard Business Review article from 2014 (an oldie, but a goodie) first turned me onto the fact that so-called “negative working capital” was such a strong driver of Amazon’s growth. At the time, the e-commerce giant had come under increasing pressure from stock analysts for its razor thin profit margins. The article points out that, while Amazon’s GAAP profits were tiny, its operating cash flow and free cash flow were surging:
In the case of Amazon, net income under-reports the cash generating power of the business because it includes massive depreciation and amortization charges. It also doesn’t account for Amazon’s attractive working capital position. A combination of these two factors drives operating cash flow to new heights each year.
Working capital advantages are worth understanding better. The key working capital metric is the company’s Cash Conversion Cycle (CCC), defined as Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) — Days Payables Outstanding (DPO). DSO is the number of days required to collect cash payments from customers, so smaller is better. DIO is the number of days it would take to sell through current inventory, so again smaller is better. DPO is the number of days it takes to pay your vendors, so the larger the better. A company is said to have achieved “negative working capital” if CCC is less than zero. At the time of the article’s publication, Amazon’s CCC was negative 30.6 days. It compares quite favorably to Walmart and Costco, two retailers who are notorious for playing hardball with vendors:
Amazon attributes its success to better inventory management (a benefit of investing so heavily in technology for its distribution centers) and the attractive terms it extracts from its vendors. For instance, its DPO at the time was nearly 96 days vs. 30 and 39 for Costco and Walmart, respectively.
How did Amazon get to this enviable position? My understanding is that it created a virtuous cycle. Amazon’s investments in distribution center technology lowered DIO. This allowed it to invest more cash in growth. Its market power with vendors increased with growing scale. That market power translated into better vendor terms, which led to a higher DPO. Higher DPO created more incremental cash flows, which it invested in better distribution center technology. And, so on…
Taking a page out of the Amazon playbook, we’ve seen startups in the apparel (Stitch Fix*), home goods (Zola*), thrift/consignment (thredUP*), and other markets innovate on their working capital model to drive additional scalability. With greater scale, these companies are seeing similar operating cash flow leverage. I fully expect that online commerce entrepreneurs in the next few years will differentiate their businesses not just by focusing on the bottom line, but on the operating cash flow line as well.
“In Amazon’s case, all this cash is being used to finance the company’s continued explosive growth. The company doesn’t need to borrow, it doesn’t need to issue stock. It can just keep spending its own cash to attack new sectors and upgrade its offerings. “The typical view on Bezos is that he’s so dedicated to the customer and he’s showing that shareholders don’t matter,” says Desai. “And the truth is, no, he has an economically fine-tuned engine that serves his goals in a really interesting and thoughtful way.”
* Disclaimer: I have an economic interest in these companies as a partner at Lightspeed or a prior fund.
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