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One of the saddest things to see is when a popular and growing DTC brand, out of nowhere, announces that they’re shutting down.
For most fans and observers, this news usually comes as a shock.
Their ads were everywhere. They were making tons of sales.
How could this have happened?
Sometimes even leadership is caught off guard, but the signs are usually there. It’s just that leadership often either notices or reacts too late.
And while there are numerous reasons that a brand can fail, the signs are usually there early on in the brand’s finances.
We’re going to look at five red flags that something might not be so great in your brand’s finances and what you can do to right the ship before it’s too late.
This article is available in video format, but if you prefer reading just scroll below.
1. Shrinking gross margin 🚩
The first red flag is a shrinking gross margin.
As a reminder, your gross margin is an indicator of how profitable your sales of your inventory are.
So, if you had revenue of $100 and inventory costs of $20, that would give you $80 of gross profit.
If you divide that $80 over the $100 of revenue, that gives you 80% gross margin.
Now, there are a number of reasons that your gross margin could decrease over time as you scale.
Decreased revenue per unit
One reason might be because you’re decreasing the amount of revenue that you’re getting per unit.
That could be because you’re relying a lot on discounting to keep increasing your overall revenue, or it could be because a lot of competitors are coming in at cheaper prices, and they’re pushing you to decrease your prices to compete.
Increased product costs
A second reason could be that the product costs are increasing over time.
That could be because of any number of reasons, but a very common one is because of the cost of shipping or freight to get the inventory from your manufacturer across the ocean to your warehouse.
Going omnichannel
And the third reason that’s fairly common for brands to see as they scale is when they go omnichannel.
While you may have started on Shopify, when you start to expand to different channels like Amazon and especially if you go into wholesale and retail, you usually have to operate on lower margins for those channels.
Now, mind you, a decreasing gross margin isn’t always the beginning of the end. A lot of times, this is an expected outcome of a change in strategy.
For example, if you decide to expand into wholesale, you might decrease your gross margin on average because of the fact that wholesale tends to be a much lower price channel, but your gross profit dollars overall might be way higher.
So, the key is really if your gross margin is decreasing in a way that you don’t expect it to.
In a situation like that, you could get into trouble because as you scale, you might be a lot less profitable than you expect.
2. Low new customer revenue 🚩
This is especially relevant for brands that have been around for a while and that have good penetration in the market.
If they have healthy brand awareness and good returning customer revenue, their overall revenue might look pretty good and sustainable.
But ultimately, returning customers are a leaky bucket. You have to keep filling that bucket with new customers that you’re acquiring.
If your new customer revenue starts to decline, it could mean that your brand is starting to lose appeal or that a competitor is starting to kick your ass.
The issue is that while things may seem fine now while you have strong returning customer revenue, eventually that revenue is going to die out.
And if you don’t have a sustainable strategy to profitably acquire new customers on an ongoing basis, you’re eventually just going to run out of a customer base entirely.
3. Negative operating cash flow 🚩
Your cash flow is essentially the net change in your bank balance over a period of time, so the net of all your cash in and your cash out.
When we say operating cash flow, we’re focusing on the cash flow that’s related to the operational side of your business.
So, we’d exclude, for example, cash in from either taking out a loan or from raising money from investors.
Operating cash flow is such an important metric because it shows whether a business, as currently run and structured, can generate enough cash flow to sustain itself.
At the end of the day, it doesn’t matter what your margins are or how profitable you are; if you don’t have cash, the business dies.
The major cash flows for an e-commerce business are usually:
- cash you spend to acquire inventory,
- money you spend on ads, and
- money you receive from people purchasing your product
And then that money is usually spent on buying more inventory.
That’s the basic idea behind the cash conversion cycle, and there are two main aspects of it that will improve your cash flow.
The first one is how much new cash is generated from that process, and that’s a function of how big the gap between your price and your cost is on the inventory and how much you spend on acquiring the customers.
So, if you buy inventory for $20, spend $80 on ads, and get $100 from a customer, you’ve basically generated no new cash.
So, in a situation like that, you either have to raise your prices, reduce your inventory cost, or improve your ROAS, which is usually the route that most people go.
But the second aspect is timing—essentially, how quickly can you convert cash from inventory to new cash coming in from a customer?
And this is where most e-commerce brands struggle. And this leads nicely into the next point.
4. Days inventory on hand 🚩
The fourth red flag is if your days inventory on hand is too high.
Your “days inventory on hand” is basically taking your inventory balance and dividing it by your cost of goods sold.
Essentially, that tells you, based on your current rate of sales, how many days’ worth of inventory you have.
If this number is too high, it means that you have way too much inventory that’s moving too slowly, and that means that there’s cash tied up in inventory that you can’t spend how you want to.
What often happens is the brand will have too much inventory tied up in the items that aren’t that popular and don’t sell that fast, which means that they have less cash available to replenish the stock of their popular items.
On top of that, the inventory usually comes with a cost to storage, so those costs are also going to be higher than necessary.
5. Contribution margin per order 🚩
Your contribution margin per order is the amount of profit left over from the sale after you’ve deducted all the variable expenses.
So, that means your cost of inventory, the shipping, transaction fees, and even the ad spend that was used to acquire that customer.
The risk that a lot of brands run into, especially if they’ve raised funds, is that they start to scale so aggressively that they’re not as attentive to how much contribution margin they’re gaining from each order.
If they scale too hard, there can be so little profit left over from the sales that they end up just having to burn through cash to cover their fixed expenses.
And if a brand does their math wrong, a lot of times they can end up in a situation where they’re actually losing net money on every customer they acquire.
While that can be a fine strategy for subscription brands or brands that have really good retention, you have to know what you’re doing if you’re going to do that. It’s a very dangerous game to play.
Your finances tell you a very honest story about how your brand is doing, so you can learn a lot if you listen closely.
These five red flags are very important to keep an eye out for, but there is a lot more depth in your finances.
So, if you need any help or have any questions, just leave a comment below. But I hope that was helpful. So, until next time, take care.
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