eCommerce insights: How to build a business plan
A year ago, I wrote about how direct-to-consumer companies are disrupting the traditional retail model and how recent shifts in consumer behavior and the supply landscape are set to accelerate the shift in the Middle East region.
Back then, I argued that the democratization of influence (social media) coupled with the decentralization of distribution channels (eCommerce) and the rise of asset-light supply chains (contract manufacturing) made it easier for anyone to set up an online store and sell products online.
In specific, you can easily sell products online by doing taking the following steps:
Ok, this is a bit too simplistic, but you get the point. It’s easier than ever to build an eCommerce business.
Unfortunately, when something becomes easy to do, everyone starts doing it, which increases the competitive rivalry in the space and makes it harder to succeed. This has recently been the case in eCommerce, and the few founders that succeeded did so by maintaining a clear and defensible value proposition and mastering their financial game. Today’s post is about that.
Taylor Holiday, the CEO of CTC, a leading consumer marketing agency and owner/ operator of 5+ eCommerce brands, rightly tweeted:
Personally, I have witnessed first-hand the complexity of managing finances for an eCommerce business and made many mistakes along the way. Through this newsletter, I hope to help some of you avoid some of these mistakes.
This post aims to guide you through building and managing the financial structure of your eCommerce business and is divided into five sections:
- The model structure
- [P&L] Understanding eCommerce economics
- [Cashflow] Why cash is king
- [Balance Sheet] Balancing it all together
- How to use the model
I’m also sharing the template that we use when assessing DTC/ eCommerce opportunities. It’s a great starting point for anyone working in eCommerce as it provides a detailed description of the most important financial metrics and how they’re interlinked.
For many of you, this piece will serve as a simple refresher of your Finance and Accounting MBA course. If you know anyone that might benefit from it, please share it with them.
eCommerce Model Structure
As you can see in the template, the eCommerce model includes 10 interlinked components:
The Input sheet incorporates your business' core assumptions, ranging from the product mix to launch timelines, sale channel expectations, and pricing/ cost figures.
The Customer Acquisition sheet projects the number of new and returning customers by analyzing your shop’s traffic, conversion rates, and customer return rates. The number of customers and the typical order profile (number of products per order) impacts the number of products ordered in the Unit Orders sheet.
The number of orders feeds into the revenues sheet, variable costs (COGS) sheet, and inventory management sheet, which calculates the number of products to hold in your warehouse based on order outflow and lead times.
The Fixed Costs sheet projects your cost structure's fixed elements (salaries, infrastructure costs, admin fees, and others).
All these components feed into the P&L, Cashflow Statement, and Balance Sheet of your company, which provide a holistic view of your company’s financial statements.
[P&L] Understanding eCommerce economics
The P&L of an eCommerce business mirrors the operational activities that a company needs to conduct to fulfill a sale order. Graphically, an eCommerce P&L looks something like this:
An early-stage consumer startup typically generates revenues from two sources:
- Its own eCommerce shop where revenues can be estimated by multiplying the number of orders by the average order value and adjusting for discounts and returns. The number of orders can be derived by multiplying the number of visitors to your website by the average conversion rate (For details on these calculations, refer to the Customer Acquisition, Unit Orders, and Revenues sheets)
- Third-party retailers, which typically charge a 40–60% retail fee (assumptions on retail volumes, timing, and fees are set in the Input sheet)
The costs associated with sustaining an eCommerce business can be categorized into a variable and fixed component.
Variable costs are directly related to your sales volume and include:
- Cost of Goods Sold (COGS): Cost of manufacturing and packaging the product. A healthy COGS rate should be kept below 15–20% of the sale price.
- Inbound logistics costs: Cost of moving finished products from your supplier to your distribution centers. It includes freight forwarding and customs and duties.
- Outbound logistics costs: Fees associated with product warehousing, picking-&-packing, delivery, and return processing. These activities are typically outsourced to a 3PL service provider, and their cost should ideally remain below 20–25% of the total order value.
- Processing costs: Order and payment processing fees (typically 2–3% of order value plus a small fixed fee). Using ‘Buy Now, Pay Later’ service providers would increase this cost bucket to 5–7%.
- Direct customer acquisition costs (CAC): Digital ad spend on social media channels, search platforms, and affiliate marketing campaigns that directly lead to sales (for details, refer to the Customer Acquisition sheet in the template)
Fixed costs are not dependent on sales and thus don’t change as volumes increase. They typically include:
- Payroll, other HR expenses, and admin and legal fees
- Infrastructure and setup fees, such as office rent, utilities, web hosting services, and monthly app fees (Shopify & al)
- Customer support (call center), although in some cases, these are outsourced to external players that charge a fixed monthly fee and a variable fee on each interaction.
- Product development fees (sampling, customer interviews, and user testing)
- Fixed marketing spend costs related to brand building, owned marketing channel management, and promotional spend.
The company’s EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) is calculated by subtracting variable and fixed costs from your revenues, and net profits are derived by removing the ITDA from EBITDA (see graph above)
A sustainable eCommerce business should target a P&L structure where variable costs are limited to 50–60% of revenues and fixed costs do not exceed 20–25%. This allows the business to maintain a 15–25% EBITDA margin and leaves room for unexpected costs and leakages in the system.
Even then, a profitable business is not necessarily a healthy one, which brings us to the Cashflow statement.
[Cashflow] Why cash is king
‘Cash is King’ is the most widely used expression in the startup world, as most startups fail when they run out of cash, which happens even when the unit economics are healthy.
As a result, you should pay special attention to your cash flows, which are linked to 3 categories: operating activities, investing activities, and financing activities (for more details on the formulas, please refer to the template)
Cash from operating activities
Cash from operating activities refers to the money generated through the company’s regular day-to-day activities and is divided into multiple three major components:
- Net profits over the same period (which can be derived from the income statement above)
- Adjustment to net profits by adding back the non-cash expenses from the income statement, such as depreciation and amortization
- Change in working capital estimates the additional amount of cash a company needs to run its day-to-day operation.
A company’s working capital is calculated by adding the accounts receivable (the amount of money your customers owe you) to the value of inventory on-hand and subtracting the accounts payable (amount of money you owe your suppliers) for a given period of time.
Negative working capital is the holy grail of business. It implies that your suppliers are the ones financing your growth, given that it takes you longer to pay them than it takes you to sell your inventory and collect your money. Alternatively, positive working capital means that you require operating cash to finance your business and thus need to continue injecting money as your company grows even when your profits are positive.
Cash from investing activities
Cash from investing activities refers to the cash spent building the company’s assets. These include:
- Capital investments (CAPEX) in equipment (for manufacturing or supply chain or brand asset development) and properties
- Investments in intangible assets such as brand assets and patents
Cash from investing activities is generally negative (given it’s spent cash) unless a company sells a division or part of its assets to an external buyer.
Cash from financing activities
The third and final component is cash from financing activities, which includes:
- Cash from equity contributions (positive when equity is injected into the company through an external investment and negative when dividends are paid to the company’s owners/ investors)
- Cash from debt contributions (positive when the company takes a loan and negative when the loan is being paid back)
Adding the three cash components together would yield the net change of cash for your company over a period of time.
[Balance Sheet] Balancing your books
The balance sheet provides an overview of what the company owns (assets), what it owes (liabilities), and the book value of its shareholders' equity.
Whereas the P&L and Cashflow statements track financials over a period of time, the balance sheet is a snapshot representing the state of a company’s finances at a specific date.
A company’s assets can be broken down into current assets and non-current assets. Current assets include:
- Cash on hand (or in your bank account)
- Accounts receivable, which we discussed above. Accounts receivable are typically low in eCommerce, as consumers pay once they place an order. However, as you move towards physical retail, days receivables rapidly pick up, given retailers tend to pay you 30 to 45 days after purchase.
- The inventory held in your warehouse, which depends on your supplier’s minimum order quantities, the average lead manufacturing times, the number of SKUs sold, and other factors. The Inventory sheet provides a good overview of how inventory is calculated based on these inputs.
Non-current assets include tangible assets, such as property, plants, equipment (net of depreciation), and non-tangible assets such as brand and patents.
Similarly, a company’s liabilities can be broken into current and non-current elements, where current liabilities include:
- Accounts payables, which consists of the money you owe your suppliers. Controlling your accounts payable is the most effective tool for reducing your cash conversion cycle and generally consists of negotiating better payment terms with your suppliers.
- Short term debt or working capital financing
Non-current liabilities mostly include long-term debt raised to finance operations.
The shareholder's equity consists of retained earnings and common equity:
- Retained earnings are calculated by adding net profits made by the business over its life and removing paid dividends.
- Common equity is the sum of equity injected into the business
Using the model
Being on top of your financial model and budget will help you make better business decisions and estimate how much money you need to raise.
The template I shared should help you get started, but keep in mind the following principles:
- Garbage in, garbage out. The quality of your model’s output is as good as the quality of its inputs. Assumptions should be stress-tested, validated, and continuously revisited to improve the accuracy of your projections.
- Simple is better. If you had to choose between simplicity and precision, you should go for simplicity nine times out of ten. A simpler structure makes it easier to understand the model and communicate with your team and investors more straightforwardly.
- Your projections will certainly be wrong, and that’s ok. The exercise itself will help you build a holistic picture of your business and understand it better. As Eisenhower once said: Plans are useless, but planning is indispensable.
- A financial model is a dynamic tool. You should continuously update the model with actual figures as each month passes and analyze it to understand the difference between your forecast and reality.
- Scenarios. Financial projects and plans are not meant to be set in stone but act as guidelines for your day-to-day decisions. Scenario analyses and sensitivity tests can generate interesting insights and help you better understand your business's growth and profitability drivers.
I hope you enjoyed this piece and found it useful. If you have any thoughts, please do share them in the comments below!
If you would like to receive the model in an excel format or a slightly more detailed version of it (with a wider product portfolio and broader distribution channels), please leave a comment, and I’ll send it to you asap.