cash-conversion-cycle-amazon

What Is Cash Conversion Cycle? Amazon Cash Machine Business Strategy In A Nutshell

The cash conversion cycle (CCC) is a metric that shows how long it takes for an organization to convert its resources into cash. In short, this metric shows how many days it takes to sell an item, get paid, and pay suppliers. When the CCC is negative, it means a company is generating short-term liquidity.

How does the cash conversion cycle work?

There are three aspects to take into account the cash conversion cycle:

  • Days inventory outstanding
  • Days sales outstanding
  • Days payable outstanding

In other words, how long it takes for an item from when it sits in your inventory to when it is sold. How long it takes for you to cash the sale. And how much time you have to pay back suppliers.

Case study

Imagine you buy from an online store (just like Amazon). You ordered an item and spent $50. You’ll get the item in 7 days. The online store has already collected the $50 and will ask the supplier to send it over to you within a week. But the store will pay the supplier only after 30 days. This means that now the store has $50 that can spend the next three weeks before the amount is due to the supplier. Those three extra weeks are crucial as the money could be spent to order other items and sell them with the same cash conversion cycle. 

Therefore when an organization learns how to use its cash conversion cycle appropriately, its financial model drives its business strategy to fuel the growth of the business.

I want to show you how Amazon uses a negative cash conversion cycle to generate extra liquidity to power up its business growth.

Related: How Amazon Makes Money: Amazon Business Model in a Nutshell

A better look at Amazon’s profitability

is-amazon-profitable
Amazon was profitable in 2021. The company generated over $33 billion in net income, primarily driven by the Amazon AWS business, which contributed to over 55% of its operating margins and other profitable parts like Amazon Prime and Ads. The Amazon e-commerce platform runs at tight operating margins since it’s built for scale.

If you look at Amazon’s income statement, you’ll see that its operating income when it comes to the e-commerce side it’s tight.

The part of the business that has high margins is related to Amazon AWS:

amazon-q1-2020-operating-income-holds-thanks-to-aws

Instead, Amazon’s e-commerce platform, while it does have much better margins compared to the past, is still low compared to other parts of the business. 

Yet, the company generates substantial cash from the operations.

Amazon’s continuous blitzscaling

amazon-cash-pandemic
Throughout the COVID pandemic, Amazon recorded a substantial increase in revenues that also resulted in more cash from operating activities (Amazon has positive cash conversion cycles). However, cash was spent from operations to expand shipping and fulfillment. And from investing activities in increasing the capability of the Amazon tech platform (AWS).
 

So how does Amazon generate so much cash from operating activities? 

The answer is in the cash conversion cycle, or the ability of Amazon to keep its operating margins low and yet generate short-term liquidity to keep expanding the business.

In fact, on the one side, Amazon has to make sure to keep its prices low, as this is part of its mission, and on the other side through the cash conversion cycle, the company can still generate cash, unlocked to grow the operations. 

This is a sort of business strategy driven by a financial model that drives the whole business. Thus, Amazon can keep its aggressive pricing strategy and yet still manage to continuously expand its operations. 

The Amazon business model, combined with its financial model made it take over several industries along the way. And it enabled Amazon to be in a continuous “blitzscaler-mode” nonetheless its size. 

what-is-blitzscaling
Blitzscaling is a business concept and a book written by Reid Hoffman (LinkedIn Co-founder) and Chris Yeh. At its core, the concept of Blitzscaling is about growing at a rate that is so much faster than your competitors, that make you feel uncomfortable. In short, Blitzscaling is prioritizing speed over efficiency in the face of uncertainty.

Understanding Amazon’s financial model 

A financial model, driven by cash conversion cycles, can be used for generating additional cash by efficiently managing three aspects:

  • Days inventory outstanding (how long it takes before we sell that item we have sitting in the store?)
  • Days sales outstanding (how long it takes to get paid by our customers?)
  • Days payable outstanding (how much time we have before we are due to our suppliers?)

Amazon is quite successful in managing its cash conversion cycle.

In fact, as of 2017, gurufocus.com reported that Amazon had a cash conversion cycle of -26.92! 

  • Amazon.com Inc’s Days Sales Outstanding for the three months ended in Dec. 2017 was 19.87.
  • Amazon.com Inc’s Days Inventory for the three months ended in Dec. 2017 was 35.27.
  • Amazon.com Inc’s Days Payable for the three months ended in Dec. 2017 was 82.06
    Therefore, Amazon.com Inc’s Cash Conversion Cycle (CCC) for the three months ended in Dec. 2017 was -26.92.

It practically means that Amazon has almost thirty days before payments are due to its suppliers, while it has already generated available cash for the business by selling items in its online store!

But how and when does it make sense to operate a cash-generating business model? I believe there are four main aspects to take into account:

  • Trust from customers
  • Digitalization
  • Negotiating strength
  • Inventory

First, you need to be Trusted by customers

Before Amazon could become so efficient in managing its cash conversion cycle business strategy, it took years to become trusted by its customers. Today Amazon.com is one of the most popular websites on earth, where each day billions of people purchased anything:

similar-web-amazon

Data: Similar Web

Digitalization makes it easier

With digitalization, it has become easier for online stores to manage their cash conversion cycle. For instance, think of the case in which you open up a store with a simple landing page. You don’t have anything down yet, but you start getting sales in.

Once an item gets pre-ordered, you can get it from a supplier and send it over to a final customer. In short, digitalization helps companies keep a more efficient inventory based on what customers order online even before they have it sitting in the inventories.

That is not an Amazon case. Amazon played the opposite business strategy: build giants super-organized inventories called Fulfillment Centers.

Fulfillment centers are the key to Amazon successful cash conversion cycle strategy

Amazon has been investing billions of dollars in automating and making more efficient its “fulfillment centers.” That, of course, helped the company to strengthen its cash conversion cycle:

Advantageous credits terms with suppliers

Another aspect is the company’s ability to negotiate convenient payment terms with its suppliers. If you’re able to stretch the payment agreement terms in a way that allows you to run your business on credit, it becomes easier to have excess cash to invest in the business operations growth. Just like Amazon has been doing in the last years.

Affiliate networks and programs

affiliate-marketing
Affiliate marketing describes the process whereby an affiliate earns a commission for selling the products of another person or company. Here, the affiliate is simply an individual who is motivated to promote a particular product through incentivization. The business whose product is being promoted will gain in terms of sales and marketing from affiliates.

Another critical element of Amazon’s successful cash business strategy was built upon a network of publishers around the web, that in exchange for a referral to Amazon products could get a fee. This is the premise of affiliate marketing, on which Amazon has also built its fortune.

Key takeaways

  • The cash conversion cycle is a crucial aspect of any business in which success is based on short-term liquidity. When current assets minus current liabilities is positive, it means the company can generate extra cash from its operations.
  • If well managed the cash conversion cycle can become a sort of cash-making machine that generates additional liquidity for an organization.
  • This is a sort of financial model that combined with a viable business model can unlock substantial growth for the business!

Below a summary of how it all works:

cash-conversion-cycle-amazon

Breaking down Amazon’s Flywheel

amazon-flywheel
The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.

Read: Amazon Flywheel

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Connected to Amazon Business Model

Amazon Business Model

amazon-business-model
Amazon has a diversified business model. In 2021 Amazon posted over $469 billion in revenues and over $33 billion in net profits. Online stores contributed to over 47% of Amazon revenues, Third-party Seller Services,  Amazon AWS, Subscription Services, Advertising revenues, and Physical Stores.

Amazon Mission Statement

amazon-vision-statement-mission-statement (1)
Amazon’s mission statement is to “serve consumers through online and physical stores and focus on selection, price, and convenience.” Amazon’s vision statement is “to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online, and endeavors to offer its customers the lowest possible prices.” 

Customer Obsession

customer-obsession
In the Amazon Shareholders’ Letter for 2018, Jeff Bezos analyzed the Amazon business model, and it also focused on a few key lessons that Amazon as a company has learned over the years. These lessons are fundamental for any entrepreneur, of small or large organization to understand the pitfalls to avoid to run a successful company!

Amazon Revenues

amazon-revenue-model
Amazon has a business model with many moving parts. With the e-commerce platform which generated over $222 billion in 2021, followed by third-party stores services which generated over $103 billion, Amazon AWS, which generated over $62 billion, Amazon advertising which generated over $31 billion and Amazon Prime which also generated over $31 billion, and physical stores which generated over $17 billion.

Amazon Cash Conversion

cash-conversion-cycle-amazon

Working Backwards

working-backwards
The Amazon Working Backwards Method is a product development methodology that advocates building a product based on customer needs. The Amazon Working Backwards Method gained traction after notable Amazon employee Ian McAllister shared the company’s product development approach on Quora. McAllister noted that the method seeks “to work backwards from the customer, rather than starting with an idea for a product and trying to bolt customers onto it.”

Amazon Flywheel

amazon-flywheel
The Amazon Flywheel or Amazon Virtuous Cycle is a strategy that leverages on customer experience to drive traffic to the platform and third-party sellers. That improves the selections of goods, and Amazon further improves its cost structure so it can decrease prices which spins the flywheel.

Jeff Bezos Day One

jeff-bezos-day-1
In the letter to shareholders in 2016, Jeff Bezos addressed a topic he had been thinking quite profoundly in the last decades as he led Amazon: Day 1. As Jeff Bezos put it “Day 2 is stasis. Followed by irrelevance. Followed by excruciating, painful decline. Followed by death. And that is why it is always Day 1.”

Connected Business Concepts

Financial Structure

financial-structure
In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.

CAPM Model

capital-asset-pricing-model
In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to build a diversified portfolio able to give satisfactory returns.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Behavioral Finance

behavioral-finance
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Value Investing

value-investing
Value investing is an investment philosophy that looks at companies’ fundamentals, to discover those companies whose intrinsic value is higher than what the market is currently pricing, in short value investing tries to evaluate a business by starting by its fundamentals.

Balanced Scorecard

balanced-scorecard
First proposed by accounting academic Robert Kaplan, the balanced scorecard is a management system that allows an organization to focus on big-picture strategic goals. The four perspectives of the balanced scorecard include financial, customer, business process, and organizational capacity. From there, according to the balanced scorecard, it’s possible to have a holistic view of the business.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Double Entry Accounting

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double entry is that a single transaction, to be recorded, will hit two accounts.

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Revenue Modeling

revenue-modeling
Revenue modeling is a process of incorporating a sustainable financial model for revenue generation within a business model design. Revenue modeling can help to understand what options make more sense in creating a digital business from scratch; alternatively, it can help in analyzing existing digital businesses and reverse engineer them.

Financial Accounting

financial-accounting
Financial accounting is a subdiscipline within accounting that helps organizations provide reporting related to three critical areas of a business: its assets and liabilities (balance sheet), its revenues and expenses (income statement), and its cash flows (cash flow statement). Together those areas can be used for internal and external purposes.

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