Vendor Financing
Ever wonder why some companies make more money than the others? Why some have a higher ROI in spite of being in the same industry as you are? While the others complain about deteriorating margins, these guys can make a lot of money without any problem at all?
Understanding the ROI formula
The Return on investment is a simple ratio, but understanding its implications can help you go a very long way as an entrepreneur. It is simply return divided by investment. You can increase your profitability, which implies increasing your selling price. And you can reduce your investment and with the same returns enjoy an increased profitability.
To take a simple example, if you were selling something for 100 bucks and made a 20% profit, you could increase this profit to 50% if your investment fell to 80 bucks. A 20% decrease in investment led to a 30% increase in profitability.
The important observation is that they are inversely related. Another important observation is that as costs keep on falling, profitability will increase at an increasing rate. So the harder they fall the better it is for you as they will propel you to a situation of leap-bound growth.
Understanding Control
Now since we know the mathematics of the ROI formula, let's see what we can do and what we cannot do. In many cases particularly in online retail, increasing your selling price will be a suicidal move. A lot of businesses are built on cost superiority. Customers want cheaper goods which are of the same quality, especially when they can see that the quality is same.
Consider a customer buying a cell phone from you or your competitor. They know that it is the same phone and they are not going to pay the cost of your inability to manage your operations effectively. So the selling price is basically market-driven.
But is it the case with costs as well? Most mediocre retailers consider this the case. So they sell at market-determined prices and pay those costs and make the normal market profit. But the smart ones don't do things differently. They know that what goes out their pocket is under their control.
Using A Little Creativity
Now just think how you can reduce your investment in business. Each time you make a purchase you pay, and each time you sell, you receive. For an average retailer, this is the chronology of events that unfold in course of a transaction:
Place order for raw materials
Pay and receive order
Hope, pray and wait for customers to turn up
Sell and receive payment
Pay careful attention to the cash flow. Money leaves your pocket at point two and returns at point four. The more the time difference, the greater amount of money you will have to put in as investment, as most people buy in bulk and sell in small lots. So you pay a big amount upfront (investment) and expect smaller parts to come back with profit.
Imagine this, how would this situation be:
Receive order to sell and receive payment
Order the supplier and take goods
Pay the supplier after a time lag
Here money enters your pocket at point one and leaves at point three. Technically speaking, you don't need any money to run your business. People are running it for you.
Analyzing The Basis Of Power
Anyone who has the control over sales has control over suppliers. So what causes you to have control - lower prices. And who funds those lower prices? Your suppliers.
The Rules of Vendor Financing
It is wrong to jump to the conclusion that anyone who goes out there and cuts prices will gain market share and can then have control over the supply chain. It requires a careful analysis of many factors like:
Power: Power here does not refer to brute strength. It depends on the ability to make choices. If you can break a relationship with a supplier and find others to deal with, while he can't find other customers as good or as big as you, you have the power. Which brings us to the classical dilemma of how does a start up build power? The answer is simple, deal with people who are relatively smaller. The idea is to enter the relationship as an equal and run the business on break-even for some time until you gain control of the sales, and then use this control to get credit, which will make you profitable.
Fixed costs: If a large amount of your costs are fixed costs, this strategy won't work. You can't ask your vendor to pay your rent or employee salary, they would simply see through it and want to get rid of you as soon as possible. Even if you have to pay them from your pocket, just eliminate them. Your job must be to convert as much of your costs into variable costs, as possible and assign each vendor the responsibility for taking care of them for a certain time period.
You will see that as your sales increase and by extension their sales increase, they will be keener to supply you trade credit and you can use that money to run your operations with virtually no money down.
Create the pull effect: The whole system runs because the customer pays money upfront and accepts a delayed delivery. This is the rule of the thumb for online businesses, and you don't have to make an effort to create this change. Under no circumstances should you pay before you receive. The idea is to be relatively bigger than both the supplier and the customer. You should have more bargaining power on each side for this to work effectively.
Plan for stock outs: In such cases, when you buy on the spot, there are instances when you have taken the order but the supplier doesn't have the goods. So make sure that you have a contingency plan. Keep standby suppliers who may be a bit more expensive. Remember customers are your source of power. If you have to take a loss or a smaller profit to safeguard your reputation, do it. Once you have made a commitment, always deliver.
Some Numbers To Consider:
Whenever you run a system, some numbers serve as important metrics to tell you the health of your operations. They are like the barometer of your success. For this strategy of vendor financing, here are the important numbers:
Cash conversion cycle: It is the difference between when you pay and when you receive. This number should always be negative. The more negative it is, the better it is for you. It means that you are running your car with your supplier's gas.
Working capital: This is another measure of the same thing. Working capital also must always be negative. This means that your current assets will be less than current liabilities. You will always owe people money, but you don't have to bother since you already have the cash and it is interest free.
Inventory levels: Once again this number should be reducing. Although this cannot be negative and you cannot have -5 goods stored with you, the number must be as close to zero as possible. Only stuff that you see a demand for must be purchased in advance. The rest must be purchased after receiving the order.
Sales: This is one number that must always be rising. For you to effectively wield your power over the supply channel, the suppliers must see you as an important customer. Someone who will make their sales grow. Their sales grow only when yours do.
ROI: Keep an eye on your ROI and that of the others. Remember it's a power game and if someone else will steal the sales, they will also steal the suppliers and maybe your entire business.
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