The Guide to Capital Efficiency
Consumer branded goods are without a doubt one of the most challenging business models in the world. It is hard enough to get everything right in order to produce a net income profit - but that is really only half the battle in this business model when you consider working capital requirements. Consumer goods are one of the only business models that can make money and lose money at the same time.
That is of course in reference to producing an accrual profit, but a cash loss in the same period after accounting for the money that was reinvested into inventory. Consider the following scenario:
- Revenue: $100,000
- COGS: $50,000
- Marketing Expense: $25,000
- Operating Expenses: $10,000
- Net Profit: $15,000
On the surface, this looks like a really strong storefront, right? 15% net income is a decent margin. However, if we dig a little deeper, the devil is in the details: working capital, or in other words - the money that needs to be moved around in order to continue to operate the business day to day (i.e., inventory, payables). The example store above may have generated 15% in accrual profits, but if the business operates with a low capital efficiency, that profit generated can very easily evaporate instantaneously. We can dive into several capital efficiency metrics and explain their uses, however let’s quickly demonstrate how a business with poor capital efficiency will actually look on a cash basis after producing 15k in net profit:
A popular measurement of capital efficiency is the cash conversion cycle days formula. The CCC is calculated using three components:
- Days Inventory Outstanding (DIO): DIO indicates the average number of days that inventory remains in stock before being sold. A shorter DIO means the company is efficient in managing its inventory.
- Formula: (Average Inventory / Cost of Goods Sold) × 365
- Days Sales Outstanding (DSO): DSO measures the average number of days it takes to collect payment after a sale. A shorter DSO suggests the company collects its receivables quickly.
- Formula: (Average Accounts Receivable / Net Sales) × 365
- Days Payable Outstanding (DPO): DPO reflects the average number of days the company takes to pay its suppliers. A longer DPO means the company takes more time to pay its bills, which can help preserve cash.
- Formula: (Average Accounts Payable / Cost of Goods Sold) × 365
CCC Calculation: CCC=DIO+DSO−DPO
So, ultimately The CCC represents the net time interval between outlaying cash for inventory purchases and receiving cash from sales. A shorter CCC indicates a more efficient cash flow cycle, as the company quickly converts its investments into cash. In our example model we are showing a CCC of 90 positive days. Instantly, we can see that despite turning a profit of 15%, our required reinvestment into inventory is $280,000 - given the assumed growth profile. This causes cash to go down immediately in the same period.
Cash Conversion Cycle is just one of many metrics used to assess capital efficiency. There are several others however:
- Working Capital Absorption Ratio: Operating Working Capital / (Annualized Revenue) * 100
- Purpose: WCAR helps measure the change in sales impact on working capital - this is mostly useful for growth businesses. In other words, this output is a good way to tell if you are going to have adequate levels of working capital to support continued growth
- Net Working Capital to Revenue Ratio: Total Net Working Capital / Revenue
- Purpose: Expressing NWC as a percentage of revenue helps us understand how the company is utilizing working capital to generate sales. The lower the output here the better, as we always want to generate more sales with less capital in the business, if possible
- Return on Assets: Net Income / Total Assets
- Purpose: ROA is a return metric that takes the profits generated by the assets on the books as a percentage. This metric is better when higher, for the same reason NWC:Revenue is better when lower; more profits, less money in assets
This idea of capital efficiency is critical in order to make sure your business is not only generating profits, but is doing so in an efficient manner. All these metrics are mostly what we call ‘balance sheet’ metrics as they are all derived from the working capital accounts in the current assets and current liabilities section in the balance sheet. Understanding your balance sheet not only at the current state, but also how it will trend is a critical part of becoming a well-rounded CFO. Being able to intimately understand, explain, and forecast the balance sheet is what separates the good from the great. Almost anyone can diagnose unit economics and read a P&L, but that is truly only half the battle.
To recap, as a CFO, it is important to make sure that the cost structure of the business is as such that the business is profitable on an accrual/net income basis - beyond that, orchestrating your operations team to plan and order inventory and your finance team to negotiate payables in a way that creates a favorable working capital cycle will 10x the impact of your marketing team’s efforts on the P&L. Tracking capital efficiency metrics like the ones we’ve outlined on a monthly basis at minimum is a great way to identify potential areas of optimization.
