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.
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
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
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.
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 for the three months ended in Dec. 2017 was 19.87.
- Amazon.com Inc’s for the three months ended in Dec. 2017 was 35.27.
- Amazon.com Inc’s 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
- Negotiating strength
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
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.
- 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
Read: Amazon Flywheel
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