Mastering Operating Cash Flow and Cash Burn Rate

Picture this: You’ve embarked on the journey of running a small business, and now, after a year of dedicated effort, it’s time to assess your company’s financial performance. Sales generate income, but expenses like equipment purchases and salaries drain your cash reserves. How do you gauge your cash position? How can you untangle the web of cash inflows and outflows to understand what remains in your coffers?

Enter the indirect method of cash flow statements, a powerful tool that unravels the intricate dance of money in your business. This method reveals the precise figures of your expenditures and earnings, helping you determine the cash you should have. It provides a sturdy foundation to grasp your business’s financial stability over a defined period.

Understanding Operating Cash Flow (OCF)

One of the most critical measures of a business’s financial health and success is operating cash flow (OCF). Operating cash flow (OCF) is a trusted indicator of whether or not a company can generate enough cash to meet its operational needs.

Understanding OCF requires a deep dive into the interconnected web of variables in the financial world. The net income of the business is the starting point because it includes all income and all costs. However, depreciation and amortization are non-cash expenses that distort net profitability. Recognizing that these costs do not affect cash flow, they are returned to arrive at a more precise figure.

Additionally, OCF incorporates changes in working capital, allowing for swings in current assets and liabilities. For instance, a rise in accounts receivable indicates cash that has not yet been collected, whereas an increase in accounts payable indicates cash that has not yet been spent. OCF provides insight into a company’s cash-generating prowess by studying these elements together.

The ability to cover operational costs, invest in growth, service debt, and stay financially robust in the face of economic crises are all highlighted by operating cash flow (OCF), making its understanding critical for investors, financial analysts, and business managers. It’s fundamental to examining a company’s finances and any severe business choices.

Importance of Operating Cash Flow

Financial analysts frequently favor cash flow metrics because they eliminate the effects of some accounting irregularities. In particular, operating cash flow helps paint a more accurate picture of how things stand with the company’s finances.

To illustrate, making a huge sale is great for income, but it only helps the bottom line if the company has trouble collecting payment. On the other side, a corporation may create huge quantities of operating cash flow but declare a relatively low net income if it has a lot of fixed assets and employs accelerated depreciation estimates.

A corporation will need to obtain short-term external sources of capital, such as financing or investment, if its primary business operations need to generate more money. However, in the long run, this cannot be maintained. Therefore, operating cash flow is a crucial metric for evaluating a business’s long-term viability.

How to Calculate Operating Cash Flow

Income and expenses from core operations like selling goods and services and paying employees are the primary focus of a company’s operating cash flow statement. Borrowing, making purchases of capital equipment, and dividend payments all fall under investing and financing activities, which are reported separately from operating cash flows. Cash flows from operations, investments, and financing can all be found on a company’s statement of cash flows.

Indirect Method

The indirect method converts non-cash items like depreciation, accounts receivable (AR), and accounts payable (AP) into cash to revise net income on a cash basis. Most businesses report their net income on an accrual basis, accounting for non-cash expenses like depreciation and amortization.

The income statement is the starting point for the indirect technique because it shows how much money the company made last year. After subtracting all costs from total earnings, we have net income. However, net income is only part of the picture when trying to determine cash flow. Depreciation and amortization, two non-cash charges, are added back to the cash flow from operations to reflect the actual cash flow from operations.

These costs do not require an outlay of cash but are deducted from net income in the accounting process. Also considered are shifts in working capital. Current assets and current liabilities are the two components that make up working capital. An increase in current assets, like accounts receivable or inventory, consumes cash, whereas an increase in current liabilities, such as accounts payable, generates cash.

The difference between the working capital after the current period and the working capital at the end of the preceding period is the working capital change.

The following formula is used for the indirect approach to determining OCF:

OCF = NI + D&A – NWC

Direct Method

The second approach is the direct method, in which a business keeps track of its financials based solely on cash receipts and payments made throughout the accounting period. Some examples of what the direct technique of operating cash flow presentation includes are:

• Employees’ salaries
• Payments made in cash to third-party providers
• Funds accrued from interest and dividends
• Paid Interest and Income Tax

The direct method provides a more detailed and transaction-based approach. It involves identifying and summing cash receipts and payments directly related to operating activities. It may include cash received from customers, cash paid to suppliers, and cash paid to employees, among others. The net cash flow from operating activities is then calculated by summing cash receipts and subtracting cash payments. OCF, using the direct method, is directly derived from this net cash flow calculation.

The following formula is used for the direct method of determining OCF:

OCF = Cash Revenue — Operating Expenses Paid in Cash

Indirect Method vs. Direct Method

​​Cash flows from operating activities, cash flows from investment activities, and cash flows from financing activities comprise the three sections of the cash flow statement. Although both the direct and indirect approaches result in the same total cash earned from operating operations, the data is shown differently.

Rather than beginning with net income on an accrual basis, the direct approach presents cash flow from operational operations as actual cash inflows and outflows on a cash basis. The indirect and direct approaches to preparing a statement of cash flows’ investment and financing parts follow the same general format.

Since the cash flow statement may be easily generated from data found in the income statement and balance sheet, many accountants favor the indirect technique. Most businesses employ accrual accounting, so the numbers you see on your income statement and balance sheet will reflect that.

To get a more accurate view of a company’s cash inflows and outflows, the Financial Accounting Standards Board (FASB) recommends the direct method. A cash flow statement-balance sheet reconciliation is advised even if the direct approach is utilized to record transactions.

Which Method is Better?

The direct method provides a more complete picture of cash flows, but it is less widely utilized because of the complexity and amount of information it necessitates. In contrast, the indirect method is more straightforward and commonly used in financial reporting. Both methods are necessary for determining the state of a company’s finances, the sources and uses of cash in its operations, and making sound managerial and investment choices. OCF can be computed using either the indirect or direct method, depending on the nature of the required financial analysis and the accessibility of relevant data.

What Is Burn Rate?

A company’s burn rate is when its cash reserves or capital are depleted over time, usually represented as a monthly or annual percentage rate. It significantly measures a business’s long-term viability and liquidity management skills.

Burn rate is when a company’s running expenses (such as payroll, rent, utilities, marketing, R&D, and other overhead) consume its cash flow. Startups and early-stage enterprises in a growth phase without sufficient revenue to pay expenses will find this statistic especially useful. It aids in estimating how long a company can stay afloat without attracting outside capital.

The term “burn rate” refers to the pace at which fuel is consumed, and there are two main kinds: gross and net. The gross burn rate is the total operational expenses without consideration of any income or revenue the company may be receiving. A positive sign of financial health is a negative net burn rate, which indicates that revenues outweigh costs.

The importance of a burn rate analysis must be balanced. Budgeting, generating money, and knowing when to seek additional funding are just some of the strategic decisions helped by this data. It helps gauge the potential financial risk a company poses to its stakeholders and investors. When there is no obvious way to turn a profit, a high burn rate is cause for concern, whereas a controlled burn rate indicates sound financial management.

For the same reason, it’s essential to know the burn rate while trying to predict the company’s “runway.” The runway is when a business may maintain operations before running out of money. Understanding how much time you have until you need to raise money again is crucial for startups and enterprises in highly competitive industries.

How to Compute the Burn Rate?

In a loss-making situation, a company’s burn rate is the rate at which its cash reserves are depleted. For businesses of all sizes, including startups, it is a standard indicator of success and valuation. In its early phases, a startup typically cannot create a positive net income because its primary focus is expanding its client base and refining its offering. Therefore, the burn rate is a common factor for investors when allocating cash to a startup.

Calculating a company’s burn rate is a straightforward process that helps measure its rate of cash expenditure, which is especially important for startups and businesses in growth phases. To compute the burn rate, you must determine the total monthly or annual cash outflow, encompassing all operating expenses, including salaries, rent, utilities, marketing, research and development, and any other costs directly tied to running the business. This total expenditure provides a clear picture of how quickly the company consumes its available cash resources.

The formula for calculating the burn rate is relatively simple: Burn Rate = Total Monthly Operating (or Annual) Expenses. For instance, if a startup spends $50,000 monthly on operational costs, its monthly burn rate would be $50,000. By understanding the burn rate, a company can estimate how long it can operate before exhausting its available capital, known as its “runway.” It is crucial for financial planning, budgeting, and timing fundraising efforts, ensuring the business has the necessary resources to sustain and grow its operations. Investors and stakeholders also closely monitor the burn rate to assess a company’s financial health and its ability to achieve profitability in the future.

Gross Burn Rate vs Net Burn Rate

The distinction between gross and net burn is easy to understand. The monthly amount spent on overhead expenses like payroll, rent, and equipment is known as “gross burn.” It does not think about money coming in.

The monthly loss of capital can be estimated using the net burn metric. It considers the money coming in and going out of your business. Therefore, if your business has high operating costs but is still making sales, the money it brings in will help reduce its net burn rate.

The net burn rate is a factor in determining the cash runway.

1. Gross Burn Rate

One measure of a business’s efficiency is its “gross burn rate,” or operational costs. It is often quantified monthly and results from adding up all of the company’s running expenses, such as rent, salaries, and other overhead. Regardless of the company’s income, it sheds light on the drivers of costs and the efficiency of operations.

The formula is: Gross Burn Rate = Cash / Monthly Operating Expenses

2. Net Burn Rate

The rate at which a business loses money is known as its “Net Burn Rate.” Profit is found by taking income and deducting operational costs. Also, this metric is tracked every month. It illustrates how much money a business requires to stay afloat for a given time frame. One thing that must be managed, though, is revenue fluctuations. If expenses remain constant while revenues decline, the result can be a higher burn rate.

The formula is: Net Burn Rate = Cash / Monthly Operating Losses

How to Calculate Cash Runway

Startups typically take several years to become profitable; therefore, having a large net burn should be fine. What you should be concerned about is your cash runway.

Your cash runway indicates how many months you have until your firm runs out of cash. Working out your cash runway is simple once you’ve determined your net burn.

Subtract your cash balance from your net burn rate. The number of months you have in your cash runway is the result.

The formula is: Cash Runway = Cash Balance / Net Burn Rate

Signs of a High Burn Rate

​​A high burn rate, defined as the quick depletion of cash reserves, seriously affects a company’s financial health and viability. Understanding these ramifications is critical for companies, investors, and stakeholders.

1. Financial Risk

A high burn rate indicates that a corporation is spending cash quickly, which could lead to a rapid depletion of available capital. This condition can represent a significant financial risk, especially for startups and early-stage businesses that may need more established income sources to fund their expenses. It heightens the need to obtain additional funding.

2. Fundraising Pressure

A company with a high burn rate frequently requires additional capital, including finding new investors, loans, or other financial instruments. This constant need for fundraising can put founders and management under strain to maintain investor confidence and meet cash requirements.

3. Reduced Runway

A high burn rate reduces a company’s financial runway—the amount of time it can function before it runs out of cash. With a shorter runway, there is less time to attain profitability, making it vital to spend resources wisely and accelerate revenue growth.

4. Profitability Issues

High burn rates can indicate difficulties in generating profitability. With significant revenue growth, a company may be able to balance its expenses and income, creating worries about the business model’s viability.

5. Dilution of Ownership

To get extra finance, businesses may issue more shares or incur debt, potentially diluting current ownership stakes. This can result in a loss of control for founders and existing shareholders.

6. Investor Caution

A high burn rate may dissuade or make potential investors more cautious, implying a more significant chance of financial difficulty. Investors may request better conditions or assurances of a clear path to profitability.

How to Reduce Burn Rate?

Layoffs and Salary Reductions

If a company has a high burn rate, an investor may negotiate a condition in a funding arrangement to reduce staff or salary. More prominent start-ups adopting a leaner approach or having just agreed to a new finance deal are more likely to lay off employees.

Development

A corporation might forecast increased growth that will benefit its economies of scale. This enables it to cover its fixed expenses, such as overhead and R&D, thereby improving its financial position. Many food delivery start-ups, for example, are operating at a loss. Forecasts for expansion and economies of scale, on the other hand, inspire investors to continue funding these enterprises in the hope of achieving future profitability.

Promotion

Companies frequently spend money on marketing to increase their user base or product usage. However, start-ups need more resources to use paid advertising. As a result, “growth hacking” is a term frequently used in start-ups to refer to a growth strategy that does not rely on expensive advertising.

Improving Burn Rate

You have two alternatives for lowering your net burn rate: produce more money or spend less of it. Let’s focus on the latter alternative because you know best how to produce money for your company. The objective is to cut spending while maintaining productivity. To accomplish this, you must increase efficiency.

Cost Management

Careful expense management is the cornerstone of burn rate improvement. Evaluate all operational costs, from salaries to overheads, and identify areas where spending can be reduced or optimized. Prioritize necessary expenses while eliminating or postponing discretionary ones.

Revenue Generation

Increasing revenue is one of the most effective ways to mitigate a high burn rate. Explore strategies to boost sales, such as diversifying products or services, expanding into new markets, and refining your pricing strategy. Growing revenue streams can counterbalance excessive cash outflows.

Efficiency

Streamlining processes and operations can lead to cost savings. Automation, outsourcing, and lean management practices can increase efficiency and reduce the need for excessive spending. It’s essential to continuously look for ways to do more with fewer resources.

Budgeting

Develop a realistic and well-structured budget that aligns with your revenue and expense goals. Regularly review and update the budget, ensuring it remains a practical financial roadmap. Budgets help prevent overruns and provide financial discipline.

Cash Flow Management

Effective cash flow management is essential for improving burn rate. Timely invoicing, minimizing accounts receivable, and managing accounts payable can optimize the cash flow cycle. Access to cash when needed reduces the pressure on available resources.

Debt Management

If your company carries debt, manage it effectively. Consider refinancing options, negotiating better terms, or consolidating high-interest debt to reduce interest expenses.

Investor Relations

Maintain transparent communication with investors about your burn rate and the strategies you’re implementing to improve it. Investors may provide additional funding or guidance if they are confident in your plan.

Productivity and Resource Allocation

Optimize resource allocation by identifying and prioritizing the most critical activities contributing to your company’s growth. Focusing on high-impact projects and avoiding distractions can increase productivity.

Cash Reserve Strategy

Establish and maintain an adequate cash reserve to provide a safety net in case of unforeseen financial challenges. A healthy cash reserve can mitigate the pressure created by a high burn rate

Exit Strategy

Evaluate your company’s long-term objectives and consider an exit strategy, such as an acquisition or merger. While this may not directly lower the burn rate, it can provide an opportunity to access additional resources and funding through a strategic partnership.

Optimizing Business Finances: Mastering Operating Cash Flow and Cash Burn Rate—Conclusion

For a company’s financial health to peak, management must have a firm grasp on operating cash flow and the cash burn rate. The burn rate evaluates the rate at which a company is spending money, while operating cash flow provides an immediate evaluation of the organization’s cash-generating capacity.

Businesses may keep their finances in order, extend their financial runway, and make well-informed strategic decisions if they pay close attention to these KPIs. Achieving long-term growth and success requires striking a delicate balance between increasing revenue and controlling costs. Learning these concepts thoroughly equips firms to weather economic storms, win over investors, and secure their financial future.