Very few eCommerce businesses survive beyond their first few years. Analysts peg the failure rate of online stores anywhere between 80 to 97 percent. There are several reasons contributing to this. For starters, eCommerce is highly competitive but has a very low barrier to entry. This attracts a lot of non-serious players to the business who close down at the very first hurdle. More significantly, financial mismanagement plays a critical role in the closure of many well-funded eCommerce stores.
This is ironic because one of the reasons eCommerce businesses are so lucrative compared to brick-and-mortar stores is they have fewer liabilities. Online stores can make do with small office spaces and very little inventory, and this is a big draw for many entrepreneurs. So why do so many eCommerce stores struggle financially?
A Primer on Working Capital
Most small business owners are already aware of their cash flow, but not all understand the difference between cash flow and working capital. Cash flow is essentially the difference between all your income and expenditure in a given period. If you earn $20,000 in a month and have to spend $15,000 in rent, salaries, and procurement, then you are cash flow positive by $5,000.
Working capital is similar, except it is the difference between all your assets and liabilities in a financial year. If all your assets (properties, inventory, income, etc.) totaled $500,000 in a year and you spent $400,000 of it to pay off loans, salaries, and rent, then you have a surplus of working capital.
Here is the tricky part. By definition, working capital does not include your liquid cash. If you face a deficit of $20,000 that needs to go into paying the mortgage, it is not realistic to sell off your property to meet the deficit. However, liquid cash or inventory that can be quickly liquidated may be used to pay this off. A business only has high working capital if there is sufficient liquidity in its operations to meet any of its immediate expenses.
What eCommerce Businesses Do Wrong
There are two main factors that fuel poor working capital among eCommerce businesses: inventory management and vendor terms. This is not unique to eCommerce. Brick and mortar stores too suffer from these factors, although their list of factors contributing to poor working capital may be larger.
On paper, inventory is listed as an asset; you can liquidate inventory just like your property or equipment. In practical terms though, this may not always be the case. For one, inventory can be a depreciating asset (technically, called “current assets” since the value changes with time). If you sell phones online, the value of your inventory may go down each time new models launch in the market.
It is worth noting that inventory is not a capital asset. A manufacturing plant or equipment is necessary to build a product, and hence vital to your business operations. This is not true with inventory which is essentially your liquid cash converted into a depreciating asset. If you do not convert your inventory back into liquid cash by selling it, you’ll potentially lose money over time.
In other words, the more inventory you hold, the more vulnerable your working capital.
Vendor terms can also wreck your working capital situation. Let’s go back to the example of an online store selling phones. This seller may procure $100,000 worth of phones from a vendor with a 60-day credit period. To maintain the current working capital, the needs to sell these $100,000 worth of phones within the next two months to pay the vendor back. If it fails to sell the phones, the business could be staring at a deficit which needs to be recovered by selling off other assets. Alternately, the business could procure a short-term loan to pay the vendor, but this does increase liabilities for future months. It is a healthier financial habit to use small business loans for capital purchases rather than paying off liabilities.
Bad vendor terms can mean only one thing for eCommerce owners—digging deeper into a hole trying to meet financial obligations.
How to Improve Working Capital
The simple, one-line answer to fixing working capital is this: improve your liquid assets and reduce your liabilities. Here is how you do it.
Reduce inventories. Inventories are a depreciating asset and a ticking time bomb. Holding too much inventory could put your business under greater pressure to sell, forcing you to try strategies you may have not executed otherwise. For instance, you may want to increase your advertising spend in order to liquidate your inventory assets faster. If your ads do not work out, not only do you continue to own the inventory, you also stack up more liabilities to your advertising partner.
Change the business model. Depending on your industry, you could look at changing your business model. A made-to-order product can allow your store to charge higher prices for a bespoke design. At the same time, you also get to sell your product before paying your vendor for the manufacturing. If that does not work, you may also look at dropshipping. With a dropshipping business model, you pass on the responsibilities for order fulfillment to your vendor. This way, you do not hold any inventory at your end and also get paid before you pass on the vendor’s share.
There are a few challenges with this model, however. Dropshipping can increase the shipping time of your product (especially if your vendor is from another country like China), and can bring down the user experience. While that is a cause for concern, it is still better than shutting down your store or filing for bankruptcy. There are other ways to deal with long shipping times.
Update vendor terms. Bad vendor terms are one of the biggest causes for poor working capital among eCommerce businesses. Each product goes through its own unique sales cycle. The time it takes for a customer buying a dress online is much shorter than it takes for one to buy a smartphone or a TV. At the same time, it costs more to hold an inventory consisting of electronics compared to apparels. Consider these factors before agreeing to your payment terms.
Establishing a healthy cash flow and working capital is paramount for any business, not just eCommerce stores. Consider hiring an advisor to assist you with managing your finances. As any successful entrepreneur will tell you, while these advisors are a liability on your balance sheet, they are one of the most important assets you can have.