Why is cash burn a misleading standalone metric?

14 August, 2013

The term cash burn has come into more common use since the mushrooming of internet startups and is more prevalent in the ‘venture capitalistic’ environment. These companies need several rounds of funding, technically referred to as Series A, B, C and so on before they turn cash positive.

Simply stated, cash burn is the amount of money that a company is spending in a month to carry out its operations. It is also an indicator of how long a company can survive before needing another round of funding or going bankrupt. The gross burn is the amount of cash spent in a month and the net burn is gross burn adjusted for cash inflows.

The average monthly cash burn is calculated by taking the difference of cash balance across two periods and dividing it by the number of months. However, cash burn as a standalone indicator can be misleading and needs to be correlated to other business parameters to better understand it. For example, the cash balance on January 1 was $3 million and that on June 30 was $2.4 million, the average monthly cash burn comes to $100K—i.e. (3-2.4)/6 months. In this case, the cash zero date will be 24 months away. So far so good, but what if out of the $600K, the company spent $200K on a one-off capex expense? Then a monthly cash burn of $66K ($400K/6) is more representative of the liquidity position and the cash zero date goes up to 36 months from 24 months.

Now taking the previous example forward, let’s assume that the company had also been elongating the vendor payments for the corresponding period, resulting in overdue liabilities of $400K as on June 30, 2013. So the company in real terms has $2 million only at its disposal and burnt $130K on an average, hence the cash zero date is only 15 months away which changes the management and investor standpoint altogether !

What is stated above is explained in the table below.

The factors mentioned below should be considered before making any interpretations around the cash burn.

  • Are there any off balance sheet items like lock-in periods in facility or other operating leases which may result in a cash outflow?
  • Do the customer or the vendor contracts have any minimum guarantee clauses? What is the probability of any liquidated damages arising out of them?
  • Have pass-through payables been included in cash balance which may result in an inflated view of the cash balance?
  • Are there any abnormal working capital items—i.e. overdue liabilities or current assets?
  • Are there any Inter BU transactions/chargebacks which are generally tracked out of books?
  • Have any one-off expenses been incurred in the period under consideration?

One can use a hybrid method— i.e. a mix of cash flow and P&L approach to iron out some of the limitations. What it essentially means is that, one takes the average realised revenue (cash realised from customers) in a month as cash inflows. On the expense side, since the monthly P&L statement is prepared on an accrual basis (not necessarily in a startup environment, one may argue!), all the expenses related to the corresponding period—whether paid or not—are already accounted for; the above cash inflows netted against the expenses is more representative of the amount of cash the business is guzzling and indicates how long it is going to last.

What mentioned above is not a straitjacket solution and has to be customised to each business. It is also good to have all the financial statements handy to make the interpretation more meaningful.

For both investors and promoters, it’s important to follow a company’s available cash, evaluating how long it will last and what will happen when it runs out. Any slip-up in calculation or interpretation around the cash burn may result in investments turning into ashes.

(Vikram Mehtani is the chief finance officer with Vriti and part of their senior management team.)

To become a guest contributor with VCCircle, write to shrija@vccircle.com.

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Why is cash burn a misleading standalone metric?

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