From Startup To Success: How a Burn Rate Model Can Help You Manage Cash Flow
By Lior_Ronen | Founder, Finro Financial Consulting
Cash flow management is one of the least glamorous yet most important aspects of a business.
After all, a business can be profitable but still run out of cash. Understanding and managing cash flow is crucial for a startup's survival, especially in the early days. One way to achieve this is by creating and maintaining a burn rate model.
In this blog post, we will explore these topics:
Understanding the startup's cash flow.
The difference between cash and profitability.
Understanding the burn rate.
Types of burn rates.
Calculating the burn rate.
Building burn rate model.
Reducing the startup's burn rate in 5 Steps.
Understanding the startup's cash flow
Cash flow is the amount of money that comes into and goes out of a business. It's the amount you have left over after paying your bills and expenses.
For startups, mastering cash flow management is essential since they often have to invest money in product development and marketing before generating revenue.
If they don't manage their money well, they can quickly run out of money, creating a cash crunch for them.
To prevent this from happening, a startup should closely monitor and constantly manage its cash. By effectively managing its cash flow, a startup can ensure that it has enough cash available to meet its obligations or unexpected events without running out of money.
Effective cash flow management can help a startup to:
Pay its bills on time and meet its financial obligations such as contracts, payroll, suppliers payments, etc.
Invest in growth opportunities, such as hiring new employees, expanding into new markets, and developing new products.
Be prepared for unexpected events—such as expenses, delays in receiving payments, or a slowdown in business.
The difference between cash flow and profitability
Cash flow and profitability are very close. They both account for money that comes into the company and money that goes out. However, a company can be profitable but still run out of cash.
Let's see what the difference is between cash flow and profitability.
On the one hand, cash flow measures the net cash left in the company after accounting for all of a company's incoming and outgoing money.
Profitability, on the other hand, measures your ability to generate income. It is calculated by subtracting expenses from revenue. However, expenses are recognized according to the generally accepted accounting principles, and they don't necessarily reflect cash movement.
As I mentioned above, a business can have positive cash flow and still be unprofitable or negative cash flow and still be profitable. How is that possible?
For example, a company with high costs that generates a lot of revenue will not have much profit. Also, a company that invests heavily in growth initiatives can still be profitable despite negative cash flow.
Both cash flow and profitability are essential metrics that a business should monitor and manage, but they measure different aspects of a company's financial health.
How to Measure Cash Flow?
To successfully manage cash flow, we need to measure it effectively.
These are the key metrics that are used to calculate cash flow:
Cash flow from operating activities (CFO): This metric measures the cash generated or used by a business's main operating activities. It is calculated by adding back non-cash expenses, such as depreciation, to the net income and then adjusting for changes in working capital items, such as accounts payable and receivable.
Cash flow from investing activities (CFI): This metric measures the cash generated or used by a business's investing activities, such as buying or selling fixed assets or investments.
Cash flow from financing activities (CFF): This metric measures the cash generated or used by a business's financing activities, such as issuing or repaying debt or issuing or buying back stock.
Net cash flow: This metric is the total cash flow, calculated by adding CFO, CFI, and CFF. A positive net cash flow means that a company has more cash coming in than going out, while a negative net cash flow means the opposite.
Free cash flow (FCF): Free cash flow measures how much cash a company generates after accounting for capital expenditures. It is calculated by taking the cash flow from operating activities and subtracting capital expenditures, often used in DCF valuation.
Burn Rate: The burn rate measures how much cash a company burns through. It is usually calculated by dividing the cash flow from operating activities and dividing it by the number of months.
Days of cash on hand: This metric measures the number of days a company can continue to operate before running out of money, calculated by dividing the cash on hand by the daily burn rate.
By monitoring key financial metrics, a business can better understand its cash flow situation.
These metrics should be used with other financial statements, such as the balance sheet and income statement, to get a complete picture of the company's financial health.
Startup Burn Rate: A Critical Metric for Managing Cash Flow
Startup burn rate is a metric that measures how quickly a startup is spending its cash reserves. It is calculated by subtracting revenue from expenses.
Burn rate is significant for startups because it helps them understand how long they have before they run out of cash, which is a critical factor in determining their ability to survive.
A high burn rate compared to a startup's cash reserves can be a warning sign that it is spending too much money too quickly and may not have enough cash to survive until it becomes profitable.
A low burn rate compared to a startup's cash reserves, on the other hand, can indicate that it is being too conservative with its spending and may be missing out on growth opportunities.
In addition to measuring the rate of spending, burn rate can also be used to forecast how long a startup's cash reserves will last.
By dividing its cash reserves by its burn rate, a startup can estimate how many months it has until its cash runs out.
By monitoring burn rate and forecasting the number of months until cash runs out, startups can make better decisions about when and how to raise more money or how to adjust spending to extend their runway.
Therefore, burn rate is a key metric for startups to keep an eye on, as it can help them to manage cash flow and stay afloat.
Types of burn rates
There are several different types of burn rates, but the most common ones are gross burn rate and net burn rate.
The gross burn rate measures how fast a company is spending its cash. It is calculated by dividing the amount of money the company spends in a month by the amount of money it has in the bank. This gives a rate at which the company is spending its funds, including all expenses such as salaries, rent, and equipment purchases.
The net burn rate measures a company's cash outflow that excludes capital expenditures. It is calculated by taking your company's operational cash outflow in a given period and dividing it by your current cash balance. This gives you an idea of how quickly you spend money on operational expenses such as salaries, rent, and marketing expenses, but not on equipment purchases or other capital expenditures.
Knowing the difference between these two metrics is essential for startups as it helps them to understand where their cash is going and where they may be able to cut costs. Net burn rate is considered a better measure of a company's operating expenses as it excludes capital expenditures which are investments that are made in the expectation of future cash flows.
There are several ways to measure burn rate. One is the daily burn rate, calculated by dividing a company's monthly burn rate by 30. Another way to measure burn rate is with expected future cash inflows and outflows, called forecasted burn rate.
Calculating the burn rate
As I mentioned above, the burn rate is the money a business spends during a specific period.
Therefore when calculating the burn rate, we'll focus on the company's cash. The calculation is pretty simple and considers the company's cash balance change divided by the number of months in a specific time period.
Let's look at a real-life example.
You have a SaaS startup that raised $1.5M in seed money. Before that round, you had $100,000 left from your pre-seed round. Six months later, you check all your financial accounts and see that $500,000 is left to spend.
So the company's burn rate is:
Starting balance = $1,500,000 + $100,000 = $1,600,000
Ending balance = $500,000
Change in cash balance = $1,600,000 - $500,000 = $1,100,000
Months in calculation = 6
The monthly Burn Rate is $1,100,000 / 6 = $183,333
The company burns $183k every month.
Building a burn rate model
We can build a burn rate model in several simple steps while sticking to a few key elements.
The first step in building a burn rate model is to get your hands on the financial data--i.e., cash balances, cash inflows, and cash outflows. We need to collect the data for specific periods like months or years and include all relevant expenses--not just salaries and rent but also services, equipment purchases, and so forth.
After you have collected the financial data, it's time to set up the model. Ideally, you'll have one sheet for each data type: cash balance sheets, cash flow statements, and income statements. Typically, we'll do that in an Excel spreadsheet, but Google Sheets could also work.
Next, you'll need to input the financial data into the model with nested formulas and calculate the burn rate as elaborated above.
Once the model is ready, you should try to make it as user-friendly as possible. You can create charts and graphs that visualize the data and show the burn rate over time.
As the startup progresses, you should keep refining and updating the model to keep it functional and valuable to the business. Keep in mind that when you update the model, you should preserve the data format. That way, you could measure the progress in your burn rate month-over-month or year-over-year.
Using the burn rate model regularly can help a startup stay afloat by identifying cash flow issues, taking corrective action, and tracking cash flow over time.
Managing cash flow with a burn rate model
By monitoring the burn rate over time, a startup can identify patterns or trends in cash flow that may indicate a problem.
For example, if the burn rate is consistently high, it may tell that the startup is spending too much money too quickly and may not have enough cash to survive until it becomes profitable.
Once cash flow issues have been identified, a startup can use the burn rate model to take corrective action.
For example, if the burn rate is high, the startup may need to cut costs or raise more money to extend its runway.
A burn rate model can also be used to forecast cash flow and estimate the months until the cash runs out, also called the cash runway. This allows the startup to plan for future fundraising and better decide when and how to raise more money.
Reducing The Startup’s Burn Rate in 5 Steps
A burn rate analysis helps the startup identify areas where it can reduce costs and manage expenses more effectively.
The analysis works in 5 steps:
1. Identify potential savings areas.
Start by identifying potential cash savings. Focus on large tick items that are one-time or recurring expenses every year.
2. Question the importance of the purchase.
Dive into the details of each item identified above and ask why we need it. Why at that specific time? What are the alternatives? Do we need that quantity?
3. Assess potential risk if the purchase is altered.
Perform a complete risk analysis of the potential associated with canceling or changing the purchase.
Ask: What are the risks of not buying that item at that time? What is the risk of not buying that item at all? Can we live without it? Can we reduce the quantity of the purchased items? What is the risk in that? Are the alternatives good enough for what we want to achieve?
4. Analyze the consequences.
Every risk above has a different financial impact on the company's bottom line. While some actions might positively affect the cash flow statement in the short term, they could devastate the business in the long term.
In this stage, we map the consequences of every risk above by examining the impact of eliminating or reducing the purchase quality. How much money does it save?
5. Putting Everything Together.
When you put all these aspects together, you start building your case towards a potential cash saving that might save X$ to the company if we take a particular action. The impact of the action is Y, but we could use the money saved on Z.
Summary
A burn rate model can be a valuable tool for startups looking to manage cash flow and stay afloat. By monitoring the burn rate over time, startups can identify patterns or trends in cash flow that may indicate a problem and take corrective action.
Building a burn rate model involves gathering monthly operating expenses, setting up the model, inputting the data, calculating the burn rate, creating charts and graphs, refining and updating the model, and using it. Furthermore, by analyzing the data and finding solutions to address cash flow issues, startups can ensure that they have enough cash to survive until they become profitable.
You can also use the burn rate model to demonstrate to venture capitalists their ability to manage cash flow, which can help to build trust with potential investors.
Every startup should use burn rate modeling to manage monthly expenses and have enough runway to stay in business.
If you have further questions or need additional assistance with creating a burn rate model, please feel free to contact me.