Episode 2: The Two Fundamentals of Business

Treehouse Metrics Podcast

Welcome to Episode 2 of the Treehouse Metrics Podcast.

You would have heard the saying “Work ON your business not IN your business”

This podcast is going to give you the skills, knowledge tools and business know how to work ON your Amazon business.

We are going to show you how to be the CEO of your business – the person who leads, develops the vision and navigates through the troubles that every business will encounter.

As the CEO, you need to look above the Jungle and map out your path to success, avoiding the quicksands that your competitors are going to walk straight into.

Today, I am going to introduce you to the two most important fundamentals of business – these apply to every business not just Amazon businesses. If we think about your business as a pyramid, then these 2 fundamentals are at the very tip of that pyramid.

Every business theory, idea, strategy, tactic, book or course – everything comes back to one basic fundamental- the one ring that binds and controls all – that basic fundamental is cashflow.

Everything that you learn about business, every activity that you undertake will lead back to increasing the cashflow from your business.

Some of you might say isnt profit the object – yes – profit is important especially how those profits convert into cash and in particular free cash – free cash being cash that does not have to be reivensted into the business.

Profit is just a measure – a concept – a standardised method of measuring how the activities of the business contribute to an increase the value of the assets of the business.

Cash is real – you can buy food for your family with cash, buy a new house, invest in another business with cash – you cannot buy any of those things with profits.

Profit is a measurement tool – cash is real.

So why is Cashflow so important.

Cashflow determines the winner – the business with the best cashflow wins. If what you are doing does not convert to cash at some stage then what is the point of doing it.

Businesses with a strong cashflow

– they can find and can advantage of more opportunities
– they can engage in activities that have less risk
– they have no restraints on growth.
– they can pay more to owners via dividends or salary
– they are able to Retain better employees
– the business is worth more
– they can resist change or react to change better or even enforce change
– they are more innovative
– they are Proactive – looking towards future – mainly because not trying to keep business open today.
– they have access to debt and capital markets – they can get money from banks and investors.
– they are less risky.

Businesses with poor cashflow:
– they are reactive – too busy just trying to operate from day to day, jumping from one crisis to next because the poor cashflow means that everything is a crisis that can wipe out their business.
– they cannot take advantage of new opportunities when they arise.
– they tend to take on risky projects – bet big on ventures to get them out of mess. or just left with the scraps.
– they are unable to grow because of cashflow constraints – cannot afford to launch new products or enter new marketplaces
– they will struggle to get money from banks and if they do get a loan then have to pay higher interest.
– they cannot find investors
– they cannot afford to pay owners because cash always has to be reinvested.
– the business is worth less or nothing at all.
– they are vulnerable to changes in the market.
– they are very risky.

In later episodes, I will show you how you can improve the cashflow of your business, how you can identify areas that are sucking up cash and how to free it.

What is the difference between cashflow and profits:

If we look at a simple Amazon business, and a position that many of you will be familar with:

As your business grows need to reinvest your profits in more stock. You need to have more stock to cover your expected growth in sales.

In an Amazon business, it can take up to a year or more, depending on your growth, to be able to take your profits out of the business. that is to have the free cashflow – surplus cash.

As an example: lets say you invest $5,000 into your Amazon business buying inventory. Because of the nature of your products, growth, deposits for suppliers, shipping times you need to have 90 days worth of stock on hand at any time. If you are selling 1,000 units per month at a landed unit cost (price including shipping) of $7.00, then you will need to have $21,000 worth of stock.

By worth of Inventory – that means deposits on Inventory, Inventory in transit and Inventory at FBA warehouses

Lets say you are making $5.00 per unit profit after advertising and expenses – That means that you would have to sell 4,200 units – that 4-5 months of sales at 1,000 units per month to generate $21000 in profits before any cash is available to be withdrawn from the business. to pay yourself a wage or even repay your initial loan.

Amazon businesses however are anything but static:

Just look at the supply side issues getting inventory ready for the 4th quarter:

1. May have to order way in advance becuase your supplier has so many other orders for 4th qtr.
2. 4th quarter sales can be highly volatile in that preXmas sales like Black Friday, Cyber monday could clean you out of inventory before you even look at December sales.
3. Chinese New Year factory closures mean that you also have to consider having sufficent inventory in place to cover January and February and even March. That may mean buying stock pre Xmas.

So we see that just the supply factors mean that Amazon sellers start to ramp up the inventory from July to get ready for the 4th quarter. The means that that rather than 90 days worth of stock at certain times you may have 6 months worth of stock at any time. The cashflow requirements over time for an Amazon business will vary between having maybe 1-2 months worth of inventory to having up to 6 months worth of inventory.

Example 1 – Profitable Businesses & Lack of Cashflow

Profitable businesses can go out of business due to poor cashflow.

Lets look at what happens to an Amazon business when cashflow is poor.

There could be number of reasons for poor cashflow:

1. Not enough capital injected into business
2. Not enough profits or continued losses in startup phase
3. Taking cash out of business
4. Growth – the faster you grow the more cash your business will need.
5. Projects or Products that did not succeed or are marginally successful
6. Too much inventory
7. Products not selling due to poor reviews, competition Amazon seasonality etc

so What happens:

1. you don’t have enough funds for next order so go out of stock – one step forward one back and then you need to relaunch those products
2. you pay more in freight or suppliers to get product back in stock quickly.
3. you Cannot afford to promote product
4. you Miss opportunities for new products becuase cash tied up in inventory of existing products.
5. you Cannot afford to test new products because cannot risk a product losing.

So the first fundamental of business is CASHFLOW – everything leads back to cashflow – profits are important but more important is how those profits convert to cash.

Fundamental #2 – Risk
So lets talk about the second fundamental of business.

Cashflow has a buddy – it sits with every consideration and business decision which is risk

The second fundamental of business is RISK

Cashflow and Risk go together – the consideration of one must take into account the other.

What is Risk?
Put Simply – something bad might happen.

As a Business definition:

A probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.

3 parts to that definition:

1. Something negative
2. Caused by External or Internal vulnerabilities
3. Avoided through preemptive action.

Risk equals loss due to vulnerabilities that can be avoided.

As your business grows, it is going to develop vulnerabilities, your job as the CEO of your business is to plug those holes in your business to reduce the risk.

Financial & Investment Definition: Risk involves the chance an investment’s actual return will differ from the expected return. Risk includes the possibility of losing some or all of the original investment.

So the first way to look at risk is volatility – if a business earnings are steady and regular – it is less risky than something that bounces around each month – high then low.

In your Amazon business, the cashflows of the business are volatile – you are not going to generate a regular amount of free cash every fortnight. If your business has profits of $10,000 per month, there will be months where you have negative cashflow as you build up your inventory, Positive months where you will generate more than $10,000 in cash each month but it is unlikely that you will be able to draw out $120,000 cash from your business. Some of those profits will have to stay in the business which is called working capital. In a later episode we will discuss working capital.

However cashflows have risk – every decision that you make has risk. Risk that it might not end up as planned due to a variety of factors.

Probably one of the most common forms of risk is concentration risk – reliance on one or small group for a major proportion of revenue or costs. Concentration risk applies to customers, suppliers, products, locations, marketing, advertising, employees, production processes.

Lets looks at
The biggest one: Amazon itself – one customer or sales channel.

The risk that Amazon will block or suspend your entire account. It has happened to our clients.

When that happens your sales fall to zero. Everything being dependent upon one sales channel.

We can of course diversify that risk but creating other sales channels our own website, other platforms like ebay walmart etsy, wholesale customers, retail distribution. The difficult part is making the decision to divert cashflow to these other channels that will not have the same return on our money and time as selling on Amazon.

We can of course reduce the risk of Amazon within Amazon itself by opening in other Amazon marketplaces like Europe and Japan but that does come with a cashflow consideration being splitting inventory and need to make minimum levels of inventory in two or more locations.

WE can reduce our product concentration risk by having multiple products. A business will have a risk if their business is dependent upon a small number of products – 80/20 rule – that is 80% of revenue coming from 20% of their products. The 80/20 rule will apply to almost every business in some form.

A Typical problem for in Amazon businesses :

* New competition into your best selling product – this is going to happen because the market knowledge is so high – Amazon has an easy to search list of the best selling products, the barriers to entry are so low – it is easy and cheap to find a similar product on Alibaba and get it listed and selling on Amazon.
* You may be able to withstand the competition from one supplier but what happens when you have 10 or 100 new competitors.
* All products have a life cycle – if you have a product that has a greater return than the rest of the market then capital and competitors will flow to that greater return until the returns of that product equal and in fact probably lower return than the rest of the market. so Profits higher than market, more competitors & price discounting until profits are lower than market and poorly performing players drop out and product returns to equilibrium.
* In Amazon, because of the low barriers to entry and high level of information or market knowledge, that process is amplified and the life cycle of a product is much shorter than in many other businesses.
* Actually you will get more and more competition on Amazon until the returns from selling Amazon are equal to that of selling products on other platforms including brick & mortar retail.
* The risk is relying upon one product because there is a high degree of probability that will have intense competition if you are successful.
* You can manage the concentration risk by diversifying your products, but this will have a cashflow cost in building up the inventory and launching those new products.

As your business grows you will need to optimise your business to manage both cashflow and risk.

The higher the risk of a business the greater return that you will need to offset that risk – greater risk requires a greater return.

which leads us the basic formula is for the valuation of a business or investment

Cashflow x Risk.

We will deal with valuations of businesses in detail in another episode but all business valuations methodologies flow from the basic formula of Cashflow x Risk – discounted cashflow model, future mainatinable earnings etc.

When people talk about the multiplier ( 24 x monthly earnings ) – 2 x annual earnings – that multiplier represents risk.
A multiple of 2 times earnings represents a return of 50%.
So the two fundamentals of business are Cashflow and Risk – they go together.

Two businesses with the same profits can have completely different cashflows.

The business with best cashflow wins: it can withstand change and competition, it leads the market rather than follows it, it has the resources to explore new opportunities.

The poor cashflow business will always be paying catchup, getting the scraps and struggling to survive.

But you have to be able to maintain those cashflows and that is about managing risk – realising that risks exist, identifying those risks and minimising the impact through preemptive action.

In later episodes, I will cover the essential business principles and methods to manage both cashflow and risk whilst growing your business exponentially.

In the next episode, I will cover the 5 multipliers of your business – understanding these multipliers and how they work together in your business will decide whether you grow exponentially or fail spectacularly.

Until next week.