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:
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 itsbusiness 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.
If you look at Amazon’s income statement, you’ll see that its operating income when it comes to the e-commerce side has been tight or harmful for most of its history. For instance, in 2022, as well, the losses from online stores generated an overall $2.7 billion loss for the company.
In short, the online stores dragged the whole company into a net loss. And yet, the online stores part is instrumental for the scale of Amazon, and it’s the underlying business unit that powers up the Amazon third-party stores, advertising, and subscription (Prime) segment.
Thus, there is a symbiotic relationship between Amazon’s online stores and these business segments (third-party stores, advertising, and Prime).
The part of the business that has high margins is related to Amazon AWS, and the interesting part is that Amazon AWS has become a business unit for its own sake, which could also work, as well, as a spun-off unit.
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
As per a FourWeekMBA Analysis, in 2022, Amazon generated over $50 billion in cash from operating activities, while it consumed almost $30 billion in investing activities and it also consumed over $22 billion in financing activities.
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.
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-generatingbusiness 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:
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 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:
Breaking down Amazon’s 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.
Amazon has a diversified business model. In 2022 Amazon posted over $514 billion in revenues, while it posted a net loss of over $2.7 billion. Online stores contributed almost 43% of Amazon revenues. The remaining was generated by Third-party Seller Services, and Physical Stores. While Amazon AWS, Subscription Services, and Advertising revenues play a significant role within Amazon as fast-growing segments.
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.”
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 has a business model with many moving parts. The e-commerce platform generated $220 billion in 2022, followed by third-party stores services which generated over $117 billion; Amazon AWS, which generated over $80 billion; Amazon advertising which generated almost $38 billion and Amazon Prime, which generated over $35 billion, and physical stores which generated almost $19 billion.
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.”
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.
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.”
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
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.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
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.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
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).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
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).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
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.
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.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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