Make sure you always have enough cash in the bank…
The next two months we’re taking a deep dive into cash management to make sure you always have enough cash in the bank. We’ll be looking at gross and net burn rates, your cash runway, analysing your receivables, strategies to get paid and associated performance indicators for you to monitor.
Recently, I was hired by a tech non-profit with a brilliant product and yet serious financial issues. An anxiety was manifest in my first board meeting. After exchanging introductions, the chairman voiced his primary concern: “What’s our cash flow situation?” Six months’ prior, the company had nearly run out of cash and the CEO had needed to suspend his salary for a few months while he raised more capital. Due to financial naivety, the company’s mission had been in jeopardy. Subsequently, I was hired to manage the financials and report them in excruciating detail to the board.
They wanted to know what the liquidity cushion of the company was at the beginning of each month for the next 12 months. In other words, what’s the current cash level, what’s the burn rate and for how many months can the company pay its expenses until it runs out of cash?
The first two things I needed to calculate were the rate at which the cash balance was going down and the date the company would have no cash left.
Here’s an example: if on January 1 you have $1.2million in cash and on September 1 you have $400,000 left, then your burn rate is $800,000/8 = $100,000 per month.
How many months of cash do you have left? You take your cash on hand and divide it by your monthly burn rate $400,000/$100,000 = 4 months until you run out of cash or December 31.
For a startup that is not yet financially sustainable, you want to have at least 9 months of cash on hand to cover expenses at all times prior to starting your next fundraising round.
If your net monthly burn rate is positive (revenues exceed your expenses each month), then congratulations: you have a financial sustainable company. However, then you still want to maintain a healthy cash cushion of at least 3-6 months.
The burn rate is especially critical when the extrinsic circumstances of the company change, e.g. when the economy takes a dive, when the company has a misstep, e.g. a product launch goes wrong, or to support progressive growth, e.g. when a new location requires time to become profitable. A strong cash reserve will also help your bank to feel comfortable in giving either a straight bank loan or a line of credit to cover an initial investment.
Additionally, the quick calculation described above is something that can be used by you, the CEO, to ensure that numbers presented by your accountant or CFO make sense.
A more sophisticated and accurate way to calculate your monthly liquidity cushion is through a rolling liquidity spreadsheet. For my clients, I require each Profit & Loss Center to produce a new version of this spreadsheet as of the last day of each month (for example, 31 August) to be emailed to me by the 5th day of the following month (5 September).
The starting point of the spreadsheet is your total cash available today, which is cash in the bank plus any available credit lines less any restricted cash that you’re not allowed to withdraw because it may be used as security against a loan.
You then subtract your total monthly expenses from your available cash. Total monthly expenses are found in your income statement, balance sheet, and cash flow statement and include salaries (operational), capital investments (investing), dividend payments, and loan repayments (financing). Adding all these monthly outlays together gets you “gross burn rate”.
Then you subtract all revenues and cash flowing into the company (cash flow that is confirmed) from total expenses and you get “net burn rate”. This is the amount of cash being spent in any given month. Total cash inflows include profit, new loans, equity issuance, and contributions (grants).
The liquidity cushion for the first month equals total cash available less total cash outlays plus total cash inflows. You then rinse and repeat for each subsequent month.
There are three KPIs that investors look for with regards to liquidity. KPIs (Key Performance Indicators) are metrics that monitor your business performance. These are:
Liquidity Cushion/(Shortfall) ($) = 6 months cash ($) – Monthly ending cash ($)
Number of months of cash available (#) = Monthly ending cash ($) / Total Expenses ($)
Net Burn Rate ($) = Total Expenses ($) – Total Revenues ($)
Investors like to talk about the number of months of “runway” available to the company given its net burn rate. They are referring to the number of months the company can operate until it runs out of money. This runway must be longer that it takes the company to achieve its operational and financial milestones and can access its next round of financing. The liquidity spreadsheet will tell you when it’s time to start raising capital again. It is critical to recognise that on average 6-9 months lead-time are required to successfully secure funding.
A mismatch in time between the cash runway and the next round of financing can arise when revenues don’t materialise, costs accelerate or funding takes longer to secure than anticipated. Burn rates can change quickly in both directions. That’s why it’s necessary to keep a close eye on your liquidity on a monthly basis.
The starting point of the spreadsheet is your total cash available today
If the amount you’re trying to raise far exceeds what investors believe you need, you’ll face some tough questions in regard to the use of the extra cash. Furthermore, if you value your company too high relative to your underlying performance, then raising future rounds of funding may become very difficult as your valuation may not be much higher 6-12 months down the road. If your performance falters, your next round may even be at lower valuation, aka a “down round”, which should be avoided if possible.
If you think having 6 months of cash on hand is far too much, then consider Zirtual, a virtual executive assistant service in the US. In 2015, this Silicon Valley startup “darling” miscalculated its cash position and didn’t have time to hit the brakes before driving off a cliff with everyone on board.
Within 12 hours of taking its last order, it laid off its 400-person staff, shut down all its social media pages, and told its clients and investors from whom it had raised $5.5million that it would be “structurally reorganising”.
The CEO had hired a virtual CFO company to help her with her financials and cash flow management, but didn’t see the need to hire full-time financial help after ending that relationship 6 months prior. During that time, business had slowed and the model became unsustainable, but no one was there to strategically help with the numbers.
A proper cash cushion would have given the CEO time to adapt in real-time and raise more capital.
Author: James Vanreusel