Cash keeps you running
When it comes to the success of a start-up, the saying “Cash is King” could not be emphasised enough. Cash is often the main reason companies stay alive longer than its competitors. It sustains businesses while seeking a new round of financing, driving rapid growth. It keeps monthly operations running to pay employee salaries, purchase raw materials and fulfil 101 other financial obligations before getting paid by customers.
A strong cash position creates more opportunities for businesses. Businesses with strong cash positions are viewed more favourably when taking up new debt and can attract new buyers with favourable credit terms.
Jack Welch, the former CEO of General Electric said: “If I had to run a company on three measures, those measures would be customer satisfaction, employee satisfaction, and cash flow.” Customer and employee satisfaction are crucial in driving demand and supply while a healthy cash flow is key in enabling the business improvements needed to enhance the first two factors.
Cash Outflows in the business
Cash flow reports details the money goes into purchasing inventories, paying salaries, capital equipment and repaying your bank loans. It allows you to monitor the recurring and non-recurring outflows that creates value for business decisions.
Every month, in order to scale your business, money goes out first to acquiring your next customer, building your sales team and paying for workspaces. The recurring nature of these expenses creates a predictable cash requirement that founders can plan for.
Large upfront investments on equipment or supply purchases that are made at the start will also take up a huge portion of the business capital. By understanding the capital impact of your decisions to grow the business, founders have a clearer idea of when to start looking for more cash. Having external investment funding for these ongoing working capital and capital expenditure is often critical to the survival of businesses in the growth stages.
Profitability is not enough
Profitability does not guarantee healthy cash flow due to credit payments structures. Revenue recorded in the books if not paid upfront, means less cash for the business at present. Similarly, expenses recorded in the books if paid off immediately, translates to less cash at the present. The net effect being a negative cashflow.
For many undercapitalised start-ups without large capital reserves, significant cash outflow leaves them in a dangerous position as cash gets burned up faster than cash that is being generated to sustain or fund opportunities for growth. Indeed, profitability is crucial when it comes to building a successful business, but in order to thrive, proper cash flow management is needed to safeguard your business.
Often, new ventures seek to prove product viability by focusing on recognising revenue first while collecting on them later. Eventually the high fixed overhead that comes with first starting out to maintain the business burns out faster than cash coming in. The seemingly viable business runs out of gas shortly because of a lack of excess funds when its most needed. This is due to inadequate business foresight and financial management . Without it, founders can only react to the crisis, which often catches them by surprise. That means having to uproot crucial task on hand to put out the fire. Proper forecasting , therefore, allows businesses to anticipate patterns and quickly close gaps during cash emergencies. Close attention must be placed as to when cash is moving in, whether it is ready at the right time, how is cash allocated and to whom should cash be prioritised for. Most often, tracking your cashflow provides alerts as to when you need to collect on your receivables and when to tighten up on credit terms to generate faster repayments.
Cash Burn Rate
One of the most important metrics for start-ups to keep track of is the Cash Burn Rate. It measures how fast the business is using up its cash stockpile and reveals your operation runway. Businesses with a high burn rate with insufficient cashflow often find themselves frantically accepting unfavourable financing terms from banks or creditors. This may do more harm to the business in the long term if the loss-generating business does not change course. Going deeper down the rabbit hole with higher interest payments and more cash to burn.
In contrast, prudent founders often anticipate the business cash flow and burn rate by preparing a realistic financial model to paint a clearer picture of the future state of the business. With a clear idea of future capital allocation and funding purpose, founders are better prepared to seek early help from angels and venture capitalists. This means ensuring the cash stockpile is always prepared for any expansion plans to grow its customer base and sales.
Cash Burn Rate (Monthly) = Cash Balance from end of previous month – Cash Balance from end of current month
Burn Rate – a.k.a. monthly operating expenses to keep the business running, eg rent, salaries, overhead, etc.
Runway/ Months Before Cash Runs Out = Capital Reserves / Cash Burn Rate (monthly)
Stress-testing your business
With clearer image of your cash runway before the next round of funding, it is prudent to create best- and worst-case scenarios based on any internal or external impacts your business is likely to face. It is not certain when the next funding round will happen, especially when unforeseen roadblocks and delays do happen. As such, planning for these scenarios is advisable.
In times of an economic contraction or pandemic when demand faces a prolonged downturn, it is likely the cash burn rate skyrockets with ongoing overheads. If decisive plans are not implemented, your business will not survive long enough before your next funding.
This means anticipating when to cut expenditures such as headcount expansion, benefits, marketing, office overheads, etc. Model in specific revenue outcomes and variable/fixed expense allocations to determine your capital requirements in each scenario. Knowing the current economic climate, you can tailor internal spending by setting limits in each segment to extend your cash runway.
Another key aspect of modelling your cash flow is to provide greater insight into the risk of a business. If the cost structure is highly fixed, the risk exposure in times of a contraction will be higher, such as rent, insurance, payroll, production facilities that you still must pay no matter what. Knowing that early gives you more time to find alternatives for a less expensive workplace or limit hiring based on projected sales goals. As always, anticipating your next move will give your business a higher chance of survival than merely reacting to any crisis.