A Disciplined Approach to the Finances of an eCommerce Business
Entrepreneurs are, by nature, product-oriented. As they work hard to offer the best possible product, they can be so laser-focused that other business elements take a back seat. Today’s eCommerce entrepreneurs are no different. They have products and services they want to sell and can sometimes be so focused on development that they forget they're operating a business -- until they run short on cash.
This presents the entrepreneur with a problem. Unless they have collateral to secure loans, traditional financing options such as loans and lines of credit may be unavailable. Business credit cards may have restrictions based on years of operation and annual revenue.
After exhausting these traditional methods, startups may find their owners dipping into personal savings or cashing in investments for added funds. A few common alternatives to self-funding include crowdfunding, investors, or friends and family. However, these sources may have little money to contribute.
Unfortunately, the scenario is all too common for small businesses. In fact, a 2022 survey found that 22% of companies fail in the first year, and 50% of companies will fail within the first five years. According to the survey, cash flow was the primary cause for 82% of business failures, and it didn't matter if the business was in-store, online, or both.
A small business finding itself with cash flow issues is likely headed in the wrong direction — and this problem requires a prompt solution. That said, a few best practices can bring discipline to an eCommerce business’ finances and keep them headed upward.
1. Start with a Plan
Small businesses often start without a plan, contrary to business advice. The owners jump into creating online stores, sourcing products, and designing marketing campaigns. They can view the time to write a plan as time away from building a business.
But plans do not have to be 100-page documents — what matters is the quality of the plan. Plans are more about setting goals, tracking performance, and adapting to change than predicting the future. They are not static documents but an adaptive roadmap for business success.
Indeed, several studies have looked at the relationship between planning and business success. One study found that businesses with a plan were 16% more likely to reach viability than identical companies without a plan.
Of course, online merchants can dive in to running their business and take the chance that everything will go well and they’ll still be around in five or more years. Or, they can increase their chance of success and start with a more disciplined approach, starting with taking the time to create a simple plan focusing on the critical components of an online business.
2. Do the Research
Before writing a word, eCommerce merchants should research their product ideas, customers, and competition. In-depth analysis isn't required, although the more data a retailer has, the better the outcome. It takes discipline for business owners to forego the thrill of a new enterprise, but without research, they're risking their company's future.
People open businesses because they believe in a product, want to be their own boss, or want to make more money. In fact, people may have all three as their motivation. Unless eCommerce merchants have done their product research, there's no way to know if their idea is viable. Ask questions to determine who your target audience is, what elements of your product will appeal to them, and how you’re solving a problem that they have. These questions and others like it will ensure you’re on the right track with your product.
Talk to people online or in person. If considering a specialty line of teas, talk to tea drinkers. Ask about what they like about online tea purchases. What is it that makes them decide to purchase online? What do they want to know before buying? Are there specific expectations that the customer has? Online merchants should continuously perform customer research to ensure their plans reflect existing market conditions.
No matter how unique a product is, there's always competition. It may not be direct, but it will be similar. If selling a line of soaps or bath essentials, look at what big box stores and boutiques are promoting. Are there promotional bundles? Is packaging part of the sales proposition? Researching competitors should become part of the daily fabric of online businesses so that a business can determine what it’s up against and integrate measures into their plan to make sure they’re staying competitive.
3. Identify Costs
Many eCommerce merchants begin operations from their homes. The cost for rental space and utilities doesn't come from profits but is absorbed by the owners. Eventually, these will become part of the business’ operational expenses as more space and people are needed. Planning should include triggers, indicating when such expenses must be paid out of the company's profits.
For eCommerce merchants, packaging, shipping, and sourcing are expenses that can eat into profit margins. Make sure to assess the costs associated with each area. This cost category should be reviewed frequently to prevent costs from consuming more profit.
How a product is packaged is as vital to success as the product. Damaged products make for a poor customer experience. They also represent added costs for the merchant. There's the cost of a replacement item and the added labor to handle the paperwork.
Minimize the potential of damaged goods by looking for durable packing materials. Cost is always a factor when it comes to packaging. Try to find the most cost-effective materials that protect the items and do not add to the shipping costs.
Shipping can quickly become the most costly component of an online business. Evaluate different shipping methods to determine which companies provide the best, most reliable service at the lowest price. Include multiple providers in a final decision to ensure alternatives are available. Today’s customers expect accurate and reliable shipping and often hold businesses responsible for any errors, so keep this in mind as you’re evaluating your shipping provider options.
Whether sourcing materials to make a product or locating products for resale, sourcing is critical to business success. How many merchants lost sales in the last two years because their suppliers couldn't deliver? Find suppliers that use a variety of shipping routes or have locations in different parts of the country. If severe weather in the Northeast delays shipments, a supplier in the Southwest could deliver a small shipment to maintain inventory.
4. Look at the Numbers
Financials should be part of every business plan. The financial plan must support the business objectives. When business owners separate financial and business plans, they often find themselves without the financial resources they need to achieve their business goals.
Gross profit margins can range from 20% to over 60%; however, a 45% gross profit margin is a reasonable target. The higher the gross margin, the lower the sales volume to break even. This number is crucial when deciding on product pricing.
Before deciding on pricing, merchants need to determine what it costs to produce their products. If merchants resell existing products, they must determine the purchase price for each item. Those selling their own products should total the cost of raw materials and associated labor. Transportation costs to receive the raw materials or products should also be included. The resulting number is the cost of goods sold (COGS).
Gross Profit Margin
Suppose a merchant has a COGS of $100,000. If the owner wants to average a gross profit margin of 45%, the business must sell a little over $180,000 in products per year. The next question is: Is $80,000 enough gross profit to pay for marketing and sales costs, labor, taxes, and other expenses?
Merchants should have a net as well as a gross profit goal. Gross profit tells an eCommerce merchant how much to sell to break even -- anything below that target margin means the merchant is losing money.
Net Profit Margin
Net profit margin indicates the amount of money that remains after all expenses, including taxes, are paid. That means paying for marketing campaigns, website upkeep, payment processing fees, administrative labor, and supplies. If those expenses total $75,000, the business owners in the above example would have a net profit of $5,000. Is $5,000 in profit annually for three years enough to meet financial goals? Putting these numbers front and center will help give direction as you adjust your plan.
5. Live the Plan
Merchants that follow a disciplined approach by building business and financial plans with data-based assumptions have a better chance of sharing in the expected $7.4 trillion in online sales by 2025. They have a roadmap that provides the agility to make decisions to ensure growth. With well-aligned plans, businesses can spend less time worrying and more time working on growing their companies. With a plan in place, eCommerce merchants can respond rather than react to market changes.
Suppose an eCommerce merchant decided that $80,000 wasn't enough profit to cover the proposed marketing campaign. However, the business owner believes the marketing effort will produce enough sales to cover a higher revenue goal. The new target is a 60% gross profit margin with $250,000 in sales.
The revised numbers show a weekly sales goal of $5,000. The plan assumes a peak sales period of November and December, with sales averaging about 19% of a merchant's annual sales. Adjusting for the peak holiday season, sales should hit a weekly average of $4,600 for the remaining ten months of the year. Having these numbers in hand early on will help you evaluate your business’ performance week to week and flag the seasons when you need to find a way to pick up steam.
Business plans are living documents. They identify key performance indicators (KPI) that businesses should track, and they compare performance to goals. Watching these numbers can alert merchants to potential cash flow shortfalls or lower-than-expected inventory.
For example, let’s imagine the eCommerce merchant mentioned above expects first-quarter sales of around $65,000, but the sales are $5,000 less than expected. That isn't a significant deviation; however, a continued loss of $5,000 for the next two quarters means a $15,000 deficit going into the holiday season.
Knowing in advance that sales are falling short allows owners to adjust spending to stay closer to the desired profit margins. They can also cue a merchant to look for short-term financing, such as merchant cash advances, to cover the shortfall.
By taking a merchant cash advance in August to cover the cost of a holiday marketing campaign, the eCommerce business keeps its cash flow at the planned level. Since the advance is repaid from credit and debit card purchases, the eCommerce business is able to benefit from the funds it needs without struggling to repay, and the merchant is heading into the highest sales season with a faster repayment opportunity.
Adapting to Change
Change often produces chaos, which is why a plan is important to long-term success. Take the supply chain disruptions of the last few years. Businesses were scrambling to find alternative sources or different supply routes. Although the disruption saw eCommerce purchases increase dramatically, the increased sales did not always translate into improved profitability.
A disciplined approach to business and financial planning enables eCommerce businesses to adapt and learn from market changes. When confronted with delayed shipments, increased transportation costs, and higher customer demand, eCommerce merchants have the data necessary to make decisions quickly.
Options for eCommerce Financing
When merchants wait to look for financing until they need it, they've already limited their options. Evaluating financing should be part of a business plan. By knowing what resources are available before they are needed, eCommerce merchants can avoid a downward spiral of growing debt.
No matter the business, loans require a strong credit score. Without a good credit history, most lenders will require collateral or a personal guarantee to secure the loan. Typically, there are no restrictions on how the loan can be used. However, qualifying for a business loan can be difficult for eCommerce merchants who lack years of operational data and no assets to use for collateral.
Business loans do not dilute ownership like equity funding and provide funds for whatever a business needs. However, business loans come with interest rates and repayment schedules. If cash flow is a problem, adding a monthly loan payment may simply compound the problem. Traditional business loans are useful for established businesses that need an influx of capital to take advantage of a growth opportunity or expansion. They do have a long approval process, so they aren't solutions for an immediate influx of cash.
Lines of Credit
Credit lines are loans used as revolving credit. Merchants borrow against their line of credit to meet expenses, such as payroll. As they repay the borrowed amount plus interest, it is returned to the available credit line. Most lenders require a minimum payment on borrowed funds. Because lines of credit are business loans, the qualifications for receiving them are the same as for other business loans, making it difficult for eCommerce merchants who lack assets or lengthy operational history.
Lines of credit are designed to help with cash flow shortfalls. When a business needs to make a tax payment or purchase added inventory, the funds can be used and then repaid. However, borrowing against a credit line without complete repayment means funds may not be available when needed. Merchants can always ask to increase their credit line, but credit lines must go through the same approval process as business loans.
Business Credit Cards
Business credit cards are revolving credit lines, usually at a higher interest rate and for lower amounts. Because credit card approval can happen within hours, it's a viable alternative to short-term funding. Credit cards can help build an eCommerce merchant's credit score if used responsibly.
Credit balances should be paid in full as quickly as possible to minimize the interest paid. Some cards can have interest rates as high as 25%. The goal should be to repay the borrowed amount in full within 30 days. Otherwise, credit card debt builds until it impacts cash flow and hurts credit ratings.
Merchant Cash Advances
Merchant cash advances are a form of revenue-based financing. To assess risk, lenders look at a merchant's credit and debit card receipts and inventory to assess risk. They then offer a loan amount based on future sales. The repayment schedule is based on revenue. For example, a lender may take 10% of each sale as repayment, leaving the merchant with 90%. The more a merchant sells, the faster the advance is paid off.
This financing option works for eCommerce merchants who lack assets and a long operational history. Businesses with cash flow shortfalls may find this option preferable to using credit cards, where the repayment amount is based on the amount borrowed. With automatic repayment, merchant cash advances can reduce the possibility of falling behind.
Onramp specializes in eCommerce merchant financing that fits an online sales model. If merchants have a slow period, they are not held to a repayment schedule. Instead of a fixed repayment plan that may incur charges for late payments and damage credit scores, Onramp bases its repayment schedule on sales.
Merchants do not have to take funds from other parts of the business to make a payment. They don't have to delay a promotion or marketing campaign to repay the financing option. With Onramp's repayment model, eCommerce merchants can grow their business while repaying the cash advance. To learn more, schedule a call to discuss how Onramp can help your business succeed.