Cash flow management is crucial for any business, but especially for startups that have limited resources and high uncertainty.
One of the key metrics that startup investors need to monitor is the burn rate, which is the amount of money a company spends each month to operate its business. The burn rate is quite simple to calculate; it is cash in subtracted by cash out. If the cash out is bigger than the cash in, the company is burning cash. While its OK to "burn cash" for a little while (while you are building the business), the burn rate can reveal a lot about the business' performance and potential. Further, it answers questions like:
- How efficiently is a company using its capital?
- How close is it to reaching profitability?
- How much runway does the company have before it runs out of cash?
- The burn rate will also influence the company's fundraising strategy.
If a company has a high burn rate or a low runway (i.e., the length of time the company can survive before being self-sustaining), and it is generating enough revenue and cash to cover its expenses, it may need to seek more funding (equity or debt) sooner rather than later, or find ways to reduce costs and increase income.
Burn rate refers to the amount of negative free cash flow that a company generates in each month without any external funding. It indicates how fast a company is spending its cash reserves. To calculate burn rate, we can use the monthly FCF or the average FCF over a longer period, such as a quarter or a year. Burn rate is also used to estimate cash runway — the number of months before a company runs out of cash. To calculate cash runway, I suggest using the average burn rate over the last three months and dividing it by the current cash balance. For instance, if a company has a burn rate of $10,000, it means it is spending about $10,000 more than it generates in revenue every month. If the current cash balance is $100,000, then the cash runway is 10 months ($100,000 / $10,000).
One useful metric to monitor is the cash-to-free cash flow ratio. Essentially, you divide cash on the balance sheet by the (negative) free cash flow. This calculates the number of years (or months, depending on the period used) the company can sustain its operations at the current pace before it will have to start to burn the furniture to keep warm. This is an estimate of the runway a company has before liftoff to a self-sustaining future without the need for external funding. If the company fails to lift off, it can crash into insolvency if external funding is not available.
The following diagram shows how cash typically comes in and out of a company. In a typical startup, cash will initially come into the company via an initial public offering of shares, where the company will sell equity in exchange for cash. The company may borrow from debt investors as well. While the company may have to purchase equipment, once it gets started, most of the cash must come from operations.
Source: WallStreetMojo
A cash flow case study
Let us take a look at Farfetch Ltd. (FTCH, Financial), an e-commerce company that fellow GuruFocus contributor Joshi Namit called the "Amazon of Luxury Retail."
The company has a cult-like following among growth investors, including gurus Bill Miller and Baillie Gifford (Trades, Portfolio).
The company has ambitious plans to build out a luxury retail platform, which luxury goods and services companies can use to sell their wares, equity investors are worried it may run out of cash.
At the end of the first quarter, the company had approixmately $486 million in cash.
Farfetch also had negativefree cash flow of about $203 million for the same period.
So dividing $486 million by -$203 million equates to 2.40 quarters (or 7.18 months) before the company will run out of cash. Of course, this is a worse-case scenario as the company is selling goods using its platform and bringing in cash as long as its gross margin is positive. But the fact remains that unless it is able turn things around in its operations (i.e., increase revenue and reduce expenses), it will run out of cash within a year or so.
As its situation is a bit dicey, it is no wonder the stock has been falling as investors nervously wait for a catalyst or for the company run out of cash.
Another example is Lyft Inc. (LYFT, Financial), the formerly high-flying ride-share company whose stock is now hitting new lows. Investors are afraid it will run out of money soon if it does not curb its cash burn or arrange for new funding.
According to the latest quarterly cash flow statement breakdown, Lyft had $740 million in cash on its books at the end of the quarter and has burn rate of roughly $121 per quarter. This means the company could run out of cash in about 18 months, given current trajectory.
Conclusion
Investors who invest in startups like Farfetch and Lyft, which are not yet profitable, should monitor the company's cash burn closely. While investors can become caught up in the excitement of a fast-growing company and sexy business model, the do not want to be left holding the bag if it runs out of cash before it can reach consistent profitability. The outcome could be dire.
In either case, it would be a total or substantial loss of investment for the stockholder. Using the new GuruFocus cash flow statement breakdown diagram is a fantastic way to monitor cash burn and runway the company has left before it runs out of money.
