Amazon.com, Cash Management, and the Global Credit Crisis
I thought I’d use my first “real” post to discuss a company that I have first hand experience with, Amazon.com. A lot has been written about Amazon.com, in particular how their focus on customers is an important ingredient to their success. In fact, there are many ingredients that contribute to Amazon’s success – one of the lesser known ones is their attention to cash management.
Amazon’s stock has a price to earnings ratio of 48.5, almost twice as much as Google’s stock. How can this be? Amazon sells physical goods like books and electronics, many of which have slim profit margins. Selling products is expensive, as I’m sure you know. You need warehouses for storage, lots of inventory on hand to meet customer demand, fleets of trucks, etc. Google sells advertisements and has incredibly huge profit margins (I’ve heard they’re over 80%). So why is Amazon’s stock so much more “expensive” than Google’s? The answer is cash management.
Let’s say that you purchase a book on Amazon.com. Amazon receives cash from this purchase almost immediately (via a credit card payment). The same is true for most retail businesses. However Amazon hasn’t paid for that book! Because Amazon has great negotiating power with their suppliers, they can demand that they won’t pay for goods for months after receiving them. In addition, Amazon’s inventory moves very quickly. They will turn over their entire inventory in just a few days (i.e. if they weren’t purchasing new products, they’d be out of everything in under a week). So when they sold you a book, Amazon has probably had it in their warehouse for just a few days, and they probably don’t have to pay for it for 2 months! In the meantime, Amazon can put that cash in the bank and earn interest on it, or use it to fund their ongoing operations (for example, to purchase more inventory for sale).
Why is this such a huge advantage? The interest on the price of a book over two months is only a few cents. The answer is working capital. Most businesses need working capital in order to operate and expand. If you run a shop, you will need a loan from the bank in order to purchase products before you can make your first sale. If the shop is doing well and you want to start a second one across town, then you’ll need a bigger loan to purchase the new inventory that you’ll sell in that shop. But amazon doesn’t need to do this. Instead of getting a loan from the bank, they are getting a loan from the customer! Because the customer is paying them before the sale, they don’t need to invest more money in order to expand. And because Amazon has been growing at break-neck speeds (15-30% per year), this is a big deal.
This is especially important in the great recession that we are living through. We are experiencing a global credit crunch – which is a fancy way of saying that it’s hard to get a loan. Business loans, home loans, credit lines, they are difficult to get because banks are scared of lending (and they don’t know how much their assets are worth). Amazon’s risk exposure to this credit crisis is therefore greatly minimized, because their need for working capital through credit is greatly reduced.
What’s the lesson here? Cash management is a great way to reduce your business’ exposure to risk in this economic climate. Negotiate hard with all of your suppliers for better payment terms. If you are paying cash on delivery, ask for to pay 30 days after delivery (Net 30). If they are giving you Net 30, ask for Net 60… or 90. Often vendors will use payment terms as a way of getting out of giving you a better price, so a great negotiating technique is to ask for a 20% price reduction, and if they don’t give it to you, insist on better payment terms instead.
If you can’t negotiate better payment terms, you might want to look for ways to get cash from you customers more quickly. If your customers are businesses and already getting terms, offering them an incentive to pay early can work great. A practice is offering 2%10, Net 30, which means that a customer has 30 days to pay, but if they pay in the first 10 days they get 2% off of their order.
Retailers can get customer to pay earlier if they are creative. Costco sells memberships for $50 in exchange for offering deep discounts to their customers. Amazon gives free 2-day shipping to their customers if they pay $80 per year. These are all way of getting customer to pay ahead of time for services that they will get later. Gift cards and gift certificates are another way to do this. The customer pays for the gift card up front, but they don’t use it for some time (if they use it at all). The key here is to be creative, and to offer customers genuine value. Customer will pay for things ahead of time if they think they are getting a good deal (e.g. Costco discounts), or if it makes their life easier in some way (e.g. Amazon Prime, or giving gift cards instead of having to think of a good gift idea).
