A higher gross margin doesn't necessarily mean a more profitable business.
In fact, chasing higher margins can sometimes be the very thing preventing your business from growing.
This is especially true for inventory-based businesses.
You negotiate a better price with your manufacturer by purchasing more inventory. Your gross margin improves. Your P&L looks better.
But now you've got hundreds of thousands of dollars sitting in a warehouse instead of in your bank account.
You improved your margins. But did you actually improve your business?
I recently sat down with Izzy Rosenzweig, founder and CEO of Portless, on the Free to Grow CFO Podcast to talk about this exact problem.
We discussed why inventory decisions shouldn't be evaluated on gross margin alone, how the speed of capital reinvestment impacts growth, and why some highly profitable businesses constantly struggle with cash.
Here are three important takeaways from our conversation.
1. A profitable business can still run out of cash
I recently worked with a brand that generated $1.3 million in profit over the trailing 12 months.
That's more than $100,000 per month in profit.
Sounds like a healthy business, right?
Except the founder had a problem.
They couldn't figure out where all the cash went.
When we looked at the financials, here's what we found:
$1.3 million in profit
$1 million increase in inventory
$500,000 in owner distributions
$200,000 net cash reduction from those three items alone
The founder had generated $1.3 million in profit, distributed less than half of it, and still watched cash decrease.
Where did the money go?
Inventory.
The business was profitable on paper, but much of that profitability had been reinvested into products sitting on shelves.
This is why looking at your P&L isn't enough.
Your income statement tells you whether you're making money. It doesn't tell you how much of that money is available to reinvest, distribute, or use to fund the next stage of growth.
For inventory-based businesses, the balance sheet and cash flow statement are just as important.
You can't pay employees, invest in marketing, or fund your next product launch with inventory sitting in a warehouse.
2. The speed of capital reinvestment matters as much as your margins
One of the most overlooked concepts in eCommerce finance is what I call compounding velocity.
Everyone understands the importance of earning a return on invested capital.
But how quickly can you get that capital back and reinvest it?
That matters just as much.
Think about two inventory purchasing strategies.
Strategy A: Purchase six months of inventory upfront to secure a better unit cost and higher gross margin.
Strategy B: Purchase smaller quantities at a slightly higher unit cost, but replenish more frequently.
Strategy A might look better on your P&L.
But Strategy B could produce a better return on the capital invested.
Why?
Because the second business can recover its cash and redeploy it into the next inventory purchase, marketing campaign, or product launch much faster.
Izzy experienced this firsthand when he operated his own eCommerce brand.
Initially, he was purchasing approximately six months of inventory at a time. His gross margins were strong, but his capital was tied up for long periods.
Eventually, he transitioned to purchasing just two to four weeks of inventory at a time.
His gross margin was slightly lower, but his cash moved through the business much faster.
He described it as a washing machine: money in, money out, money in, money out.
That shift helped him scale the business from approximately $200,000 to $2.5 million in revenue without hitting the same cash constraints.
The lesson?
You don't just want to maximize the return on your capital. You want to maximize how frequently you can earn that return.
And sometimes that means accepting a lower gross margin in exchange for faster inventory turnover.
3. Margin percentages don't grow your business. Margin dollars do.
I had a founder ask me recently what EBITDA margin they should be targeting if they eventually want to sell their business.
My response was simple.
Stop obsessing over EBITDA margin percentages.
Start thinking about EBITDA dollars.
Of course, margins matter. They tell us something about the efficiency of a business.
But percentages alone don't pay the bills.
Let's look at two hypothetical businesses.
Business A
$5 million in revenue
20% EBITDA margin
$1 million in EBITDA
Business B
$10 million in revenue
15% EBITDA margin
$1.5 million in EBITDA
Business A has the higher EBITDA margin.
But Business B generates 50% more EBITDA dollars.
Assuming everything else is equal, which business would you rather own?
The one generating $1 million in EBITDA or $1.5 million?
It's the same principle with gross margin.
If you can turn inventory faster, sell more products, and generate more total margin dollars with less cash tied up in inventory, you've potentially built a stronger business even if your gross margin percentage is lower.
And this matters even more for apparel brands.
An apparel brand might have six months of winter inventory sitting in a warehouse during spring and summer.
That inventory might still carry a great theoretical gross margin.
But it isn't producing cash.
Worse, the cash tied up in winter inventory might be preventing the brand from purchasing the spring and summer products customers actually want.
Now you've got too much inventory that isn't selling and not enough inventory that could be selling.
That's a capital allocation problem.
The goal isn't to maximize the margin on every unit you purchase. It's to maximize the dollars your business can generate from the capital available to it.
The bottom line
I'm not suggesting gross margin doesn't matter.
It absolutely does.
You need healthy unit economics. You need to generate enough contribution margin to cover operating expenses. And you need a business model that can ultimately produce sustainable profits.
But optimizing for the highest possible gross margin at the expense of cash flow can be a costly mistake.
The better questions are:
How much capital does this inventory purchase require?
How quickly will we recover that capital?
What other opportunities are we giving up by tying up this cash?
Will this decision generate more total profit and cash over time?
These are the questions that should drive your inventory purchasing and capital allocation decisions.
Because at the end of the day, the business with the best margins doesn't necessarily win. The business that can profitably turn its capital the fastest often has the advantage.
I explored these ideas in much greater detail with Izzy Rosenzweig, CEO of Portless, on Episode 83 of the Free to Grow CFO Podcast.
We also discussed alternative fulfillment models, reducing inventory requirements, and how brands can improve cash flow without sacrificing their ability to grow.
Listen to the full episode on the Free to Grow CFO Podcast.
